Investors are often told the myriad reasons why they should invest in index funds. Index funds, they are told, offer minimal fees and easy diversification. They are simple to track and require little short-term management. And, of course, they never beat the market but often do beat the average investor, hedge fund, or mutual fund.
All of these accolades are accurate. Index funds are, indeed, incredibly easy, flexible, and reliable as investment vehicles. They are great options for most portfolios. Whether you own dozens of stock or have all your investments in a savings account, whether you’re new to the market or have worked on Wall Street for years, there are very few portfolios – and investors – for which an index fund would not be appropriate.
So it is understandable that everyone and their mother is an index fund advocate, especially considering the substantial losses suffered by many hedge funds and stock market gurus during the recent recession. But, as with anything in life, index funds are not perfect. They are not right for every single portfolio. And they have their own shortcomings and qualifications.
What are these shortcomings? Let’s take a look:
Can’t beat the market
By definition, an index fund cannot beat the market. This means that it will usually rise as the market rises over time, but it carries little hedge against an economic downturn and its offers little chance of substantial returns during a boom period.
No insurance against volatility
There was once a time when the market’s rises and falls were stable – far more stable than the average individual stock. That has changed in the past several years, as the market has seen some of its highest highs, lowest lows, and biggest one-day and one-week swings in recorded memory. While index fund ownership once made for a smoother investment ride, the current large-scale nature of volatility insures that this is no longer the case. In fact, trading cash for platinum or gold may be a more stable pursuit these days.
Chance of annual losses
Index funds are not actively managed and thus do not accrue the same transaction taxes common to mutual funds and other investment vehicles. But changes do occur when companies enter and exit an index. If you invest in an S&P 500 index fund, for example, the companies that drop out of the top 500 will be removed from the index. Since these companies have also often experienced a decline in their stock value, their departure can translate into an annual loss for the investor.
Early redemption fees
Index funds are known for being low-fee and no-fee investment propositions. While this is often the case, and although annual fees are universally small, index funds still sometimes carry charges – many of them hidden and geared towards keeping the investor for the long run.
Less strategy involved
Most investors are content to put their money aside and check back infrequently to insure that it continues to grow. Some people, however, enjoy the challenge and excitement of investing. Such investors will likely find index funds boring and disappointingly hands-off.
These are the major shortfalls of index fund investing. While they are certainly minor and not applicable to many investors, such shortfalls should nonetheless be considered when any portfolio decisions are being made. After all, the bad should always be considered alongside the good – even if the latter generally outperforms the former.