5 Reasons To Avoid Index Funds

AAA

Modern portfolio theory suggests that markets are efficient, and that a security's price includes all available information. The suggestion is that active management of a portfolio is useless, and investors would be better off buying an index and letting it ride. However, stock prices do not always seem rational, and there is also ample evidence going against efficient markets.

So, although many people say that index investing is the way to go, we'll look at some reasons why it isn't always the best choice. (For background reading, see our Index Investing Tutorial and Modern Portfolio Theory: An Overview.)


1. Lack of Downside Protection

The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.

You can choose to hedge your exposure to the index by shorting the index, or buying a put against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing (it's a breakeven strategy). (To learn how to protect against dreaded downturns, check out 4 ETF Strategies For A Down Market.)

2. Lack Of Reactive Ability

Sometimes obvious mispricing can occur in the market, but in a broad market value weighted index, exposure to a mispriced stock or sector may be minimal. Active management can take advantage of this misguided behavior in the market. An investor can watch out for good companies that become undervalued based on factors other than fundamentals, and sell companies that become overvalued for the same reason.

Index investing does not allow for this advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock.

3. No Control Over Holdings

Indexes are set portfolios. If an investor buys an index fund, he or she has no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands. (To learn about socially responsible investing, see Change The World One Investment At A Time.)

4. Limited Exposure To Different Strategies

There are countless strategies that investors have used with success; unfortunately, buying an index of the market may not give you access to a lot of these good ideas and strategies. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks an S&P 500 Index would track.

If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. You may be able to provide yourself with a better-positioned portfolio than the overall market, or one that's better suited to your personal goals and risk tolerances. (To learn more, read A Guide To Portfolio Construction.)


5. Dampened Personal Satisfaction

Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape.

On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money. (To learn more, see Create Your Own U.S. Equity Portfolio.)

Conclusion

There have been studies both in favor and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it's not always the best route to achieving your personal investing goals.
Related Articles
  1. Investing Basics

    5 Reasons To Avoid Index Funds

    Stock values don't always behave in rational ways, so blindly counting on index funds can be a mistake. Here are five reasons why.
  2. Mutual Funds & ETFs

    The 4 Best U.S. Equity Index Mutual Funds

    Find out which four index mutual funds are among the best U.S. equities index mutual funds for core holdings in your investment portfolio.
  3. Options & Futures

    The Lowdown On Index Funds

    If you can't beat the market, why not join it? Read on to go over your options.
  4. Mutual Funds & ETFs

    ETF Tracking Errors: Protect Your Returns

    Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
  5. Professionals

    Average Market Returns

    We look at the major indexes and their average yearly returns.
  6. Stock Analysis

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  7. Investing Basics

    The Pros and Cons of Indexes

    Learn about the advantages and disadvantages of stock indexes and passive index funds. Discover how there is an opportunity cost to using index funds.
  8. Mutual Funds & ETFs

    Make Sure You Avoid Adding These Mutual Funds to Your 401(k)

    Find out which five types of mutual funds you should avoid in your 401(k), including why buying this year's hottest fund is likely a losing bet.
  9. Mutual Funds & ETFs

    Index Investing: Index Funds

    Indexes are great tools for telling us what direction the market is taking and what trends are prevailing. So, how do we buy into these investment vehicles? Imagine the costs associated with ...
  10. Mutual Funds & ETFs

    3 Best Global Equity Index Mutual Funds

    Discover three no-load and low-fee global equity index mutual funds that can add worldwide diversification and steady returns to a portfolio.

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center