Index funds have become a powerful driving force in the investment world. According to statistics, one-fifth of all money invested in US stock markets is invested in index funds.
Index funds are exchange-traded funds that can be easily traded using online brokerage accounts established for broad market exposure with low operating costs.
One of the main ideologists of the index fund was John Bogle, the founder of Vanguard.
Bogle initiated the first index fund in 1976. Thousands of index funds are available now on the trading floors by country or industry.
Index funds are becoming a trend now because it is easier to get started with limited knowledge, but there are downsides to investing in index funds. So before diversifying in an index fund, it is better to weigh all the pros and cons of index funds.
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Pros of Index Funds
Investors are attracted to index funds because of their low risk, high performance, and low fees. They are attractive to those who prefer a passive investment strategy – take your hands off the decision wheel and let your assets grow on autopilot.
Here are the advantages of index funds:
1. Easy to get started without investment knowledge
Index funds can easily make diversified investments by purchasing only one product.
For example, investing in an index fund linked to the Standard and Poors index (S and P 500) Index has the same effect as investing in the 500 major American companies.
If you invest individually, you need investment knowledge and a lot of time to select stocks that are likely to progress in the future from a large number of stocks.
You can quickly start investing without detailed investment knowledge with an index fund.
2. Lowest costs and commissions
Index fund managers rarely make investment decisions, so they don’t need to hire researchers or analysts. These savings are passed on to investors through lower fees and management costs.
The average expense ratio of an index fund is around 0.49%, and some are as low as 0.03%. These types of funds allow you to create a diversified portfolio on safer, low-fee securities.
Reliability is manifested in the fact that, over a long distance, the index outperforms the returns of most investors.
Over the decade since 2011, the US benchmark S and P 500 has returned 13.6% per annum. 82% of investors failed to repeat it.
You should also know that the index is designed for constant growth due to rebalancing: unprofitable companies leave the index, and promising companies enter it.
Instead of buying individual stocks that require knowledge and time to select and analyze, you buy hundreds or thousands of companies at once.
Diversification within this ready-made portfolio minimizes your risk – if one stock depreciates for a particular reason, this will not affect the portfolio as a whole.
5. Passive control
Many investors are not interested in managing their investments; they want to increase their money steadily. Index funds do not require decisions, so they are great for inattentive investors.
The term that you are looking for is Passive investing. The approach differs from active investing, an investment where the investor tries to outperform the index.
Passive investing is an investment technique where the investor’s priority is to match index returns by recreating index weightings.
Regarding investing, security is always a sensitive issue, and many believe everything concerning investments is hazardous and high-risk.
After all, index funds offer you the certainty that they are considered unique assets. So if the publisher of the index funds goes bankrupt, your money managed there is protected and will not be touched in the event of insolvency.
7. Insured against the risk
Shareholders of index mutual funds are insured against the risk of making a mistake in choosing a management company.
In the case of other categories of mutual funds, they can find excellent solutions but also miss significantly, leaving “in the red.”
By becoming a shareholder of an index fund, you insure yourself against the potentially harmful influence of the human factor and do not blame yourself in the future for not taking the time or failing to choose the right manager for your funds.
Index funds are an ideal portfolio tracker for Individual investors as they can mitigate risk and maintain transparency.
8. Spread of risk
With index funds, the spread of risk is even greater. An index fund on the Euro Stoxx 50 reflects the development of all 50 stocks and an index fund on the American index S&P 500 the development of 500 stocks.
And if you buy an MSCI World ETF, you get the performance of more than 1,500 stocks worldwide. Regarding risk diversification, index funds do even better than individual stocks.
To spread your risk appropriately by buying individual shares, you need at least 50 different stocks from different regions and industries.
Index funds offer a simple and inexpensive alternative to stable returns and asset allocations..
A curtailed capital gain distribution of index funds makes asset sales less frequent than their counterparts.
Capital gains happen when investments are sold for more than purchased, and the federal government taxes them. Smaller capital gains make this investment option more tax-efficient.
You have greater transparency with index funds. On the one hand, this is achieved because the price development can be forecast with relative certainty by using the respective index as a guide. On the other hand, you can check the index fund’s portfolio of securities daily.
11. Smaller tax bills
Investing in index funds also means you will have to pay fewer taxes. It is because actively managed funds buy and sell a lot of stock, and you may have to pay taxes every time they do.
Index funds don’t do this enough to reduce your tax exposure.
12. Good operational results
Index funds are said to achieve better than many active funds on a performance basis.
While active funds have the potential to achieve high results, investment performance is sensitive to the capabilities of fund managers. As a result, some funds are well above the index, and others are well below.
A 2019 study by S and P Dow Jones Indices revealed that 85% of US large-cap active management funds fell below the index in 10 years.
Rather than spending time for beginners looking for active funds that continue to outperform indexes, buying index funds first will start asset formation sooner.
13. Easy tracking
If you decide to bet on index funds to know what will happen with your investment, it will be enough to review the general behavior of the index you are trying to imitate.
They are easy to understand. A person without extensive knowledge in financial matters could invest in an index fund and understand its evolution and behavior without significant inconveniences.
14. Expert advice
Although they are practically automated investments that digitally replicate the behavior of other markets, they are still managed by a person who will be in charge of searching for and buying assets among the more than 1,000 index funds worldwide.
Cons of Index Funds
There are also downsides to index investing. For example, the shares of some companies may be panic-sold, and index funds, due to the existence of an appropriate agreement, are not entitled to sell them. It can lead to losses for ordinary investors.
Other disadvantages of index funds are:
1. Requires a certain trust fee
Despite the low cost, trust fees are, of course, costly. Some index funds require higher trust fees than active funds. Be sure to check when choosing a product.
2. Unsuitable for Dividend
Index funds are unsuitable for fans of dividend strategies involving living on capital since the funds’ dividends are reinvested for further asset growth.
Some investors, especially those with small capital, may not like the lack of explosive growth of an asset that can happen with individual stocks. The yield of the index is still limited.
3. Unsuitable for short-term gain
A diversification strategy limits losses if one stock falls, limiting your ability to profit from well-performing stocks. So index funds are not seeing the big rallies that some investors hope for quick profits.
However, you can also include active funds and shares in your portfolio to compensate for these disadvantages in addition to index funds.
Furthermore, as a customer, you have neither capital nor currency protection. It would be best to reduce the risk of currency loss by implementing currency hedging.
4. Lack of flexibility
The investment memorandum obliges the index fund to hold assets regardless of market conditions. For example, when markets decline, an active fund manager may sell assets and repurchase them later to cut losses.
An index fund can’t do that even during an extended market downturn. Thus, investors are guaranteed the reference index’s profitability and the index’s loss in the event of a market fall.
5. Not easy to customize
You can choose from many different types of index funds. You can get bond funds. It is possible to obtain ESG funds.
You can also get Millennial Themed Funds and Live Cattle Stock Funds. But you can’t personalize what’s inside.
To do this, you will have to select the actions yourself. It upsets some people if, for example, they buy an ESG index fund and find it is still investing in some companies that they disagree with for the time being.
You can always check the fund’s prospectus to see what’s in the mix.
6. Tracking error
The difference between the return of an index fund and the return of its “parent” index is a reflection of the cost of managing the fund’s assets.
It is called “tracking error.” When comparing index funds with the same benchmark index, choose the one with a minor tracking error.
7. No exact match for index returns
Index funds can never precisely match their target due to fees. Index funds can underperform their benchmarks as a result of tracking errors.
This issue can be caused by the target components not being counted according to their weights in the index.
8. Non-ideal composition
A significant disadvantage of index funds is the need to keep shares of unpromising companies in the profile from an investment point of view.
According to a study by Goldman Sach, excluding stocks that have underperformed the index by more than 50% for three consecutive years from the S and P 500 Total Return would increase the index’s return by about 7%.
9. Principal is not guaranteed
If you choose a stock investment trust, the price may drop significantly or rise significantly. Bond investment trusts have smaller price movements than equity investment trusts, but their principal is not guaranteed.
As long as it is an investment, there are fluctuations in the principal, so be fully convinced in advance that there is a possibility that the principal may break due to market trends before investing.
10. Inability to duplicate the most successful approaches of fund managers
The main drawback of an index fund is that actively managed funds have outperformed index funds in the past. It is expected to continue in the future as well.
A fund manager brings a lot of experience and follows a structured investment approach. He analyzes companies, meets with their economic research desks, and relies on real-time events and trend analysis; he can make decisions that help the fund outperform.
In addition, a fund manager can limit the downside by holding performing stocks and changing strategy if the need warrants.
Index funds fall in the same proportion as the markets, as they also have to remain invested in unprofitable stocks.
11. Dependence on Robo advisors
If we want to contract an index fund, we can do it through the bank, a broker, or entities such as Robo advisors. If we are not investment experts, one of the disadvantages may be that we have to choose which fund best fits our investment objectives and risk profile.
An alternative to automated advice at a low price is Robo advisors. These automated investment managers combine a human team of investment experts with algorithms that automate part of the investment process.
After testing our financial situation, the Robo-advisors automatically recommend several index fund portfolios adjusted to our profile and risk tolerance. An index fund investment portfolio is a set of several index funds where our money will be invested.
Valuable Tips before investing in index funds
- Bond Index fund investing is passive funds that require fund holding. It is better to analyze your financial goals before becoming an investor.
- The choice of investment firms for better investment gains. The share price, low-cost index funds, minimum investment requirement, safer investments, and government-backed securities are requirements that you must watch before investing.
- If you prefer aggressive investments, you should go for funds managed by active managers rather than Bond index investing.
- Returns to investors in this portfolio of bonds managed by the passive portfolio manager are dependable upon growth-oriented securities, annual returns, market returns, market cycles, stock prices, and business success.
Index investments are an exciting alternative to traditional investments in individual securities.
Because the investment structure of index funds is known in advance and does not require constant operations in the market, management fees are relatively low.
The downside of index investments is their high exposure to industry risks. Index funds are perfect for investors with a long investment horizon who want to invest cost-effectively and know their risk tolerance.
Quick Comparison (Pros and Cons of Index Funds)
|High level of security||Poor profitability|
|Inexpensive due to the absence of front-end load, the ongoing fees are significantly lower||Requirement of a high level of trust fees|
|Diversified investment also possible with smaller investment sums||May miss out on chances that are available in other small and mid-cap markets|
|Transparent||Active management needed to choose the product and the area to be indexed|
|Small expenses||Deal with periods of instability in the equity markets due to not being linked with other assets|
|Simple and understandable strategy||Auto-following trends leading to investors falling into a market bubble|
|Lesser risk as we know in advance that we are going to earn the same return as the market dictates||Lack of professional corrections|
|Easy review of the general behavior of the index that you are trying to imitate||Possibility of tracking error|
(Last Updated on August 5, 2022)