There are advantages and disadvantages to using stock indexes and the index funds that track them. An index is an imaginary portfolio of securities representing a particular portion of the broader market. The stock index can provide a statistical measurement of the stock prices in that portfolio. An index is typically constructed using the shares of leading companies in the economy or in a particular sector.

Key Takeaways

  • An index gives a quick measure of the state of a market.
  • Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently.
  • On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
  • Several prominent investors and numerous respected academics believe most people are better off with index funds.

Indexes first became popular with the Dow Jones Industrial Average (DJIA), which was created by Charles Dow in 1896. The DJIA was the second stock index, created after the Dow Jones Transportation Average. The DJIA became a crucial tool for tracking the strength of the broader economy. Since then, other stock indexes have become popular, including the S&P 500 and the NASDAQ Composite. Many indexes track other asset classes, such as bonds and commodities.

Numerous low-cost index funds track stock indexes. Some prominent investors, such as Warren Buffett, have championed the use of index funds for the average investor.

Advantages of Indexes

Stock indexes provide an easy way to track the overall health of a market. By looking at one statistical measurement, it is easy to gauge the current state of the market. Further, the historical data of index movements and prices can provide some guidance to investors as to how the markets have reacted to specific situations in the past. That can help investors to make better decisions.

Advantages of Index Funds

There are also several advantages to index funds. The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. Exchange traded funds (ETFs) are often index funds, and they generally offer the lowest fees of all. That can save investors money over the course of their lives since less of their investment gains go toward fees and expenses.

Academic studies have shown index funds outperform active management funds over time. Even a manager who consistently beats the market can show diminishing performance. Thus, it often makes sense for many investors to include index funds as a portion of their portfolios.

Another benefit of index funds is that they allow investors to achieve their goals relative to benchmarks more consistently. For instance, consider an investor who wants to beat the market and is willing to take more risks to achieve that goal. Investing 90% in a low-cost S&P 500 ETF and 10% in a 2x S&P 500 leveraged ETF will often beat the market. There is no risk that a fund manager picks the wrong stocks with this approach. The only risk remaining is when poor or mediocre market returns cause leveraged ETFs to underperform the market.

Diversifying stock holdings with ETF index funds in other asset classes can reduce the volatility of a portfolio. Government bond funds often provide a good hedge against stock market declines.

Disadvantages of Indexes

There are issues with the calculation of stock indexes that can lead to disadvantages. For example, the DJIA is a price-weighted index. The index is calculated by taking the sum of the prices of all 30 stocks in the index. This sum is then divided by a divisor. The divisor is adjusted based on stock splits, spinoffs, or other changes in the market.

Stocks with higher prices have a larger impact on movements in the index as compared to lower-priced stocks. As a price-weighted index, no consideration is given to the relative size of the industry sector of the stock or its market capitalization. Another criticism of the DJIA is that it represents a thin slice of the blue-chip universe since it contains only 30 companies.

On the other hand, the S&P 500 is a market-cap-weighted index. It is calculated by taking the adjusted market capitalization of all the stocks in the index and then dividing it by a divisor. Similar to the DJIA, the divisor is adjusted for stock splits, spinoffs, and other market changes. The main drawback to the S&P 500 is that the index gives higher weights to companies with more market capitalization. The stock prices for Apple and Microsoft have a much greater influence on the index than a company with a lower market cap. The S&P 500 index does not provide any exposure to small-cap companies, which historically produced higher returns.

1:57

5 Reasons To Avoid Index Funds

Disadvantages of Index Funds

There are also disadvantages to using index funds for investments. The lack of flexibility limits index funds to well-established investment styles and sectors. Furthermore, stock indexes experienced a great deal of volatility in 2020. The index funds merely followed the stock indexes downward. However, a good active manager may have been able to limit the downside by hedging the portfolio or moving positions to cash.

Another key drawback of index funds is the inability to duplicate the most successful fund managers' approaches. While there are many choices for value investing ETFs, there are far fewer growth at a reasonable price (GARP) ETFs. Furthermore, GARP ETFs seem unlikely to duplicate the long-term performance of a master of that style, such as Peter Lynch. Finally, fund managers are constantly devising new strategies. Even the most successful strategies will not spawn ETF imitators for years to come.