Investing in index mutual funds and ETFs gets a lot of positive press, and rightly so. Index funds, at their best, offer a low-cost way for investors to track popular stock and bond market indexes. In many cases index funds outperform the majority of actively managed mutual funds.

One might think investing in index products is a no-brainer, a slam-dunk. However, to nobody’s surprise, the providers of mutual funds and exchange-traded funds (ETFs) have created a slew of new index products in response to the popularity of index investing. Here are five things to know about index funds as you plan your investment strategy.

Not All Index Funds are Cheap

People that work for large multi-national corporations often have the opportunity to invest in index funds offered in 401(k) plan that are dirt cheap institutional funds. If your 401(k) plan contains index funds from providers such as Vanguard Group or Fidelity Investments, you can be pretty certain these are low cost. Both fund families offer share classes with even lower expense ratios and also offer a full range of index funds across various stock and bond asset classes.

Many 401(k) plans, unfortunately, do not offer index funds that are not this cheap. This may be true if your plan provider is an insurance company or brokerage firm offering their own proprietary funds. While the advice to focus on index funds in your 401(k) plan is often sound, make sure that you look at the index funds offered in your plan to ensure that you are making the best choices. For 401(k) participants fortunate enough to have a selection of several low cost index funds, the advantage over higher cost active funds can be significant.

All Indexes Aren't Created Equal

There are a wide range of low-cost index mutual funds and ETFs covering widely used indexes across the nine domestic Morningstar style boxes, as well as widely used foreign stock indexes. The same holds true on the fixed income side of things.

The proliferation of ETF index products in recent years has led to a whole slew of index funds with underlying indexes that were essentially created in the “lab” with results that are largely back-tested as opposed to having real market results. While back-testing is a valid analytical tool, investors need to be careful about ETFs using indexes that consist of a large amount of back-tested historical results. To my knowledge there are no rules governing the underlying assumptions used in applying this data and the simulated results may not be an accurate portrayal of the risks of ETF.

I personally am much more comfortable sticking with mutual fund or ETF that tracks an index based on real market data.

Index Funds Don't Necessarily Reduce the Risk of Loss

Investors in an index fund or ETF tracking the S&P 500 during 2008 lost roughly 37% plus the fund’s expenses reflecting the decline in the underlying index. Investors in index products tracking real estate in the form of a real estate investment trust (REIT) or emerging market stocks suffered large losses as well.

Index fund investors do, however, eliminate manager risk. This is the risk of an active manager underperforming the benchmark associated with their investment style due to the investment choices they make in managing the fund.

Underlying Indexes May Change

Vanguard, who is a large player in both index mutual funds and ETFs, recently changed the underlying indexes for a number of their core index mutual funds such as Vanguard Mid Cap Index (VIMSX), Vanguard Small Cap Index (NAESX), and several others. This was done in large part due to the fees Vanguard had to pay the previous index provider in an effort to maintain their status as one of the lowest cost index fund shops. There doesn’t appear to have been an adverse impact here, but again, index fund investors need to stay on top of their holdings for changes like this, which I suspect will be more common as ETF and mutual fund providers continue to compete on price. 

Index Funds Don't Ensure Investment Success

Just investing in an index fund or two doesn't mean that you're on your way towards achieving your investment or financial planning goals. Index funds are tools just like any other investment product. In order to gain the most benefit from using index funds either exclusively or in combination with active funds you need to have a strategy.

Index funds work quite well as part of an asset allocation plan. Index funds (at least the ones tracking basic core benchmarks) offer purity within their investment styles. Many financial advisers put together portfolios of index funds that are allocated in line with their client’s risk tolerance and their financial plan. Others may use a “core and explore” approach where index funds make up much of the portfolio (the core) with selected active funds to hopefully enhance returns (the explore portion).

1:57

5 Reasons To Avoid Index Funds

The Bottom Line

Investing in index mutual funds and ETFs can be an excellent low cost strategy for all or a part of your investment portfolio. Like any other investment strategy, investing in index funds requires that you understand what you are investing in. Not all index products are the same and investors need to look beyond the “index fund” label to ensure they are truly investing in a low cost product that tracks a benchmark that fits with their investing strategy.