A Definition of Index Funds
The History of Index Funds
The State of Index Funds in 2019
The Benefits of Index Funds
The most-often cited pro of index funds is the one you’ll see marketed from nearly every provider. Index funds can offer lower fees and expense ratios than other types of funds.
If you want cheap equity exposure there is nothing better than an index fund.
For the average DIY investor, index funds help to create a diverse portfolio without doing much work. Rather than balancing your asset allocations across the individual stocks you picked out, you can grab an index fund instead and own everything.
The Drawbacks of Index Funds
Just like index funds offer some benefits, they can also include several drawbacks.
These are the most important cons to understand about investing only in index funds.
One of the most important elements of managing a successful portfolio is understanding your level of risk, and how much risk you must endure to achieve the gains necessary to meet your financial goals.
An index fund, by its very nature, tracks with the market. As such, it’s not possible to fully align your true personal risk tolerance with the risk an index fund introduces.
Remember that when a bear market comes around, an index fund guarantees you’ll suffer 100% of that market decline—it is tracking what the market’s doing, after all.
These bear market declines from major indices can be unnerving for even the most aggressive investors. Major market indices have all, at one point in time, declined in excess of -50%.
Source: YCharts 12/31/2018
Part of the reason why index funds don’t offer good risk management is that they tend to gravitate toward a narrow set of high-performing, in-the-moment stocks.
As more money flows to all the same stocks, their prices go even higher, and they become more and more overvalued. In the case of the S&P 500, it’s a capitalization weighted index; that means that money invested in a given index fund does not get evenly distributed across all 500 stocks. The five largest S&P 500 stocks have a market capitalization equal to the bottom 282 stocks!
The risk management most investors may think they’re achieving by investing in an index fund is not spread as evenly as many assume.
How much risk management is in place by owning many times more shares of Microsoft, Apple and Amazon than more defensive companies in the index?
Index Funds Can’t Always Give You Access to New Niches
Indexing, by its focus on broader market performance, doesn’t always offer access to niches that could offer better chances to align performance and risk with a portfolio’s needs.
The places where active management has the best chance of delivering superior performance are the niches where indexing is less established, or more difficult to establish a solid foothold.
Index Funds Rarely Get the Best Price
If one of the core benefits of index funds is that they offer lower costs, then you’d think that they also should always save an investor money in other ways too. But that’s not necessarily true.
Too often, index funds violate the first rule of good investment behavior buying stocks when their price is high, and selling them off when they’re low.
Typically, companies will only be removed from an index when they’re at their lowest point. The company that replaces them isn’t going to be some also-ran who can’t create profits for their shareholders. It’s going to be a higher-valued entrant than the company that just exited.
As a result, index fund investors often are not getting the best prices on the stocks owned within an index fund.
The Potomac Approach to Investing
At Potomac, we believe there’s a time and a place for everything in investing. We are not dogmatic believers that passive strategies always win, nor are we always going to advocate for more active strategies when another may result in better results.
We believe in the flexibility of tactical management. Sometimes, the best decision is to hold a passive fund. Other times, the expertise of a seasoned stock picker will add more value.
Blindly following the passive movement that has dominated the airwaves and led to the incredible increase in index fund investing can be problematic for investors approaching retirement, especially as very different market cycles take hold.
When we work with our clients, we focus on creating risk-managed, personal portfolios that are built to an individual’s or a family’s goals and needs.
You may not need to outperform the market, and you may not care to track with the market either if that’s not what your financial goals call for.
Putting a focus on real-life situations and not performance return numbers can create a positive perspective shift when you’re evaluating life after retirement and decreases the financial stress that can come with risky investments that don’t match your personal situation.
We also take a rules-based approach to investing. By operating through a set standard, we attempt to alleviate those large bear market losses that passive investors simply must accept and wait to end.
If you’d like to see what it’s like to be a Potomac client, please connect with us to begin the conversation.