Index Funds Are Nice-Not Perfect

Index funds have become popular for good reason. Just don't think of them as some sort of cure-all for every portfolio.

If you watch any prime time television or sporting event, chances are you’ve seen some advertising for index funds, which can offer a low-cost way for investors to track popular stock and bond market indexes. Index funds invest in securities to mirror a market index, such as the Dow Jones Industrial Average or the S&P 500. On behalf of investors, who purchase shares of the fund, the fund buys and sells securities in a manner that mirrors the composition of the selected index.

Much of the positive press around index funds makes sense. These next three statements are all true of index funds. 1. In recent years, some index funds have outperformed actively managed funds 2. Because they mirror an index, these funds ensure diversification. 3. Index funds are inexpensive in comparison to actively managed funds. While those “facts” about index funds can be true, they can sometimes be false as well. As with all investing strategies, you should consider the caveats, the relative nature of those statements, and the fact that the return of most investments changes over time. Here are some things you should know about investing in index funds.

Index Funds Aren’t Always Cheap

If you’re investing in an index fund through a 401(k) or 403(b) plan, it may indeed have a very low expense ratio. Some firms offering their own “in-house” or proprietary funds may not be low-cost at all. Yes, they are still likely to be less expensive overall than other types of funds, but costs can still add up. Make sure you know how the fees associated with the fund are structured, exactly what they are, and how they compare to your other investment opportunities.

Past Performance Doesn’t Necessarily Predict Future Results

Physician’s Money Digest

If you’re a regular reader of , the subhead above should look very familiar, but it’s worth mentioning again here. Just because several prominent index funds have outperformed managed fund accounts in recent years doesn’t mean they will continue to do so. There are also many types of index funds and exchange-traded funds that have under-performed the market. Yes, look at historical data of a fund’s performance as part of your due diligence, but understand that past performance is no guarantee and shouldn’t be the only factor in your investment decision.

Index Funds Aren’t Necessarily Diversified

Index funds work quite well as part of an asset allocation plan, and they can be adjusted to match your risk profile and investment goals. But because they track an index, and because many index track specific industries (such as technology, health care, real estate, etc.), the funds themselves are not necessarily diversified. They should be one component of a diversification strategy—not the whole enchilada.

A Final Word

Index funds have other potential negatives as well, including the inability to control your holdings in individual securities and pursue securities that you think might represent a good value. Many still find them quite valuable, and for good reason. Just don’t think of them as some sort of cure-all for every portfolio.