In finance, an index is a statistical measure or indicator. Similarly, an index fund is a fund that builds its investment portfolios around a financial market index. Thus, the index fund mimics the composition of the financial market index it tracks.
For instance, if stock A makes up 2% of the Nairobi Stock Exchange (NSE), any fund that tracks the NSE will mimic that composition and ensure that stock A makes up 2% of its portfolio.
Investing in index funds is also passive investing, meaning it has fewer trading activities. Investors or portfolio managers do not practice stock picking and market timing, unlike actively managed funds.
Index funds provide investors with portfolios that reflect the entire market. Investors who invest in this investment product do so because they believe the whole market will outperform individual stocks in the long run. But is this investment product completely safe?
John Bogle, the founder of Vanguard Group, has warned about the dangers of index funds.
Read the review of Bogle’s Book The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns
He said the funds are creating a bubble, which will hurt the market in the long term. Other experts have also claimed that index funds remove the element of price discovery from financial markets because they do not care about the valuation of individual stocks.
Here are some reasons why you should be careful about index investing.
Index Funds Are Not The Same
First, it is important to note that index funds are not built the same. Some have higher management fees than others. This will ultimately reduce your net earnings. As you shop around for an index fund that meets your investment needs, ensure you consider the management fees from the available options in the market. Do not just settle for one fund without comparing notes.
Read more on Investing 101: Investment vehicles for a beginner
Vulnerability to Market Swings and Crashes
When the financial market performs well, your investment in the index fund will give you great returns, but when the market crashes, your entire portfolio takes the impact of the crash. For example, in the 2008 global economic crash, investors tracking the S&P 500 lost 37% of their holdings.
Lack of Flexibility
If a stock becomes overvalued, the rational investor reduces their portfolio exposure to that security. Unfortunately, index investing prevents you from making such wise decisions. Instead, the bloated security will have more weight in the market, exposing your portfolio to overvalued assets.
Also, if the entire market is declining strongly, there is little the managers can do to salvage the situation. In contrast, managers of mutual funds will make quick decisions to protect investor funds.
You Get No Control Over Your Holdings
Investors that buy into index funds have no control over the individual assets that make up the portfolio. They are fixed portfolios. You may have specific companies you like from your brand research, but investing in index funds would prevent you from making decisions about the exact firms you want.
For religious or other sustainable user reasons, some investors prefer not to invest in certain companies. However, index investing does not respect this since it mimics the entire market. Instead, active mutual funds provide investors with a wide variety of investment products, allowing investors to choose investment products or strategies that match their beliefs or ethical convictions.
Limited Investment Strategies
Today, there are a large number of investment strategies being used to achieve success. For example, mutual funds may employ strategies that provide you with a better hedge against risks than an index would. If you choose to become an individual investor, investing in carefully researched selected companies may provide you with better returns than the index.
No Big Gains
Index funds do not aim to outpace the market. If you invest in them, you give up the possibility of making massive gains from the market. The best mutual funds consistently outperform the best index funds. When you compound the difference in returns over many years, the result can be significant.
Each form of investment has its unique benefits and downside. For example, index investing is best for multi-decade investments like pension funds, where the investor seeks ‘Average return.’
Before choosing any form of investment, carefully research its benefits and downsides to help you make the best decision. We recommend you work with a professional financial adviser to help you understand the best investments suited for your needs.