Question

What are the downsides of index funds?

Answer

Firstly, sorry I’m a bit late on this one, 30 June is fast approaching!

I haven’t yet covered index funds (or much investing at all) in my content so will quickly outline what an index fund is and why I think they’re great.

What is an index fund?

An index fund is an investment fund where a fund manager buys all of the companies in the index it’s trying to track to replicate the index.

Wait, what’s an index? On the news, you might hear about the ASX200 or the All Ordinaries (Australian indexes) or the Dow Jones or the S&P 500 (US indexes). These are basically measures that aim to track a group of companies (shares) on the stock exchange. e.g. the ASX200 is comprised of the 200 largest companies (by valuation in Australia) inline with how valuable they are.

If you invest $10,000 in an index fund that tracks the ASX200, for example, you have exposure to something like the below:

Commonwealth Bank of Australia – 7.96%

BHP Group Ltd – 6.55%

Westpac Banking Corp – 5.42%

Telstra Corp Ltd – 2.57%

Woolworths Group Ltd – 2.39%

… you get the idea

In most index funds, the larger the company the higher the allocation e.g. the Commonwealth Bank is the most valuable company on the Australian Stock Exchange (ASX).

Index funds are often confused with Exchange Traded Funds (ETF’s) however they’re not exactly the same.

It is true that most ETF’s are index funds however ETF’s are just a vehicle to get exposure to investment trusts and there are actually ETF’s that aren’t index funds.

There are two main ways to invest in an index fund: via a managed fund where you generally invest directly with the fund manager (fill out forms, transfer funds etc.) or open a share brokerage account and buy ETF units (similar to how you buy shares in a company) that are issued by the fund manager.

There are some small pros and cons of each of these methods (that I won’t go into today) but they’re both often good options and the decision either way often depends on the individuals circumstances (investment size, possible withdrawals/investments in the future, the size of these, the frequencies of these etc.).

So why are they good?

As I previously covered here, fees are very important and the biggest attraction of index funds is their low fees. There are two main reasons why I see them being cheaper:

  1. There’s less work involved to track an index than there is to hire an active portfolio manager, hire investment analysts who meet with companies etc. and this is reflected in the cost.
  2. Vanguard was the first index fund decades ago (and is one of the biggest providers, if not the biggest) and they have an unusual model (a little different in Australia) where the fund management company is owned by the index fund investors, essentially making it a not-for-profit. As the biggest player in the industry isn’t trying to make a profit it means other viable competitors need to be cheap too otherwise they wouldn’t be competitive.

As fees come off an investors return, lower fees = higher returns.

But active fund managers could outperform the index so it’s worth paying the fee?

True, they can. But history suggests that this is not the case over the long-term with only a small % of funds able to outperform the market over a long period of time and the chances of picking the winner are even slimmer.

The world’s most famous investor Warren Buffett didn’t really become well known for his skill until the 80’s, 30 years into his career. There have now been hundreds of books written about Buffett and his methods and as far as I can see the first one published was in 1998, over 40 years into his career.

Few people were smart and lucky enough to know that a 26-year-old working out of his house in the middle of America would go on to become the richest person in the world.

There will be other Warren Buffett’s and people who do very well in the stock market but the chances of identifying this person or fund manager before the fact and then overcoming the fee hurdle are slim.

As the late founder of Vanguard Jack Bogle said “Don’t look for the needle in the haystack. Just buy the haystack!”.

Other advantages of index funds are:

  • They’re often more tax efficient than active funds
  • They’re very diversified so you’re not as exposed to a particular share or bad decision of a fund manager
  • Less need to think about your investment decision e.g. did I choose the right fund manager, how’d he/she perform this year?
  • More transparent
  • More accessible with smaller minimum investments and don’t necessarily need a financial adviser to access them

So what are the downsides?

Volatility/risk

I almost didn’t add this as it’s not exclusive to index funds and affects active funds more or less the same but the biggest risk of index funds (particularly invested in growth assets) is the risk that your investment loses value. Share markets are volatile and can (and will) go down and stay down for an extended period of time so to manage this risk you must have a long investment horizon (say 7+ years) to give the market time to recover should it decline.

Guaranteed to be boring

Probably the biggest downside of index funds is that as you’re not trying to outperform the index so you’re not going to see spectacular returns, particularly not over the short-term.

Some people don’t like the thought of being mediocre and prefer to go against the “science” and choose a fund manager they think can outperform the market and make them richer. Working with retirees over the years, they love to chat about shares and outperforming active funds with their golf buddies. Investing in the ASX200 is unlikely to give you bragging rights with a great story or recommendation, at least not over the short-term.

I have no problem with helping clients implement a more active strategy if they’re that way inclined but the problem with this is that the numbers are stacked against you.

Index funds won’t make you extremely rich on their own but when coupled with regular savings and compounded returns, they’re a great way to get ahead.

100% exposed to shares

Another disadvantage with index funds is that they’re just about 100% invested in the market whereas active fund managers can choose to hold an allocation to cash if they think that share prices are high and reduce risk. This means that index funds get around 100% of market rises and around 100% of market declines.

Some fund managers perform better when equity markets fall as a result however it’s just about universally accepted in the investment space that no one can consistently time the markets and if a fund could, it would show up in their superior performance. Again, a small % of funds have superior performance over the long-term. If you want to reduce your risk, there’s nothing stopping you selling down a % of your index fund.

No flexibility

Another disadvantage is that there’s no flexibility in the strategy and you’re forced to have higher allocations to older established companies with less growth, industries that have “challenges”, “overvalued” companies, less exposure to “the next Facebook” etc. This is true but the premise of index investing is also that financial markets are “efficient” meaning all positive/negative things are already factored into the price of a share/financial security because there’s 1000’s of people trading the shares every day deciding on what the correct price is. If this didn’t hold up and active fund managers could successfully use their flexibility, again, they’d outperform over the long-term.

Most active fund managers (especially the more established ones that people want to invest in after it’s performed strongly) also aren’t that “active” as they don’t utilise their flexibility to its full ability. Why? Because they’re businesses that make money by managing money and rely on their past performance to continue managing money. Financial advisers (who have to answer to clients) don’t enjoy explaining to clients why their investments are underperforming so will look for alternatives if they’re underperforming and fund managers want to avoid this as it reduces the amount of money they manage and the revenue of their business. Fund managers, therefore, prefer to be a little bit right than being very wrong and by doing so they might forgo entering into high-risk/high-reward opportunities even if they have conviction.

Further, an index fund may not be appropriate for you if you’re targetting something more specific e.g. more capital growth, more income, more franking credits, environmentally friendly companies etc. Although there are some index options that aim to target these, you might want to look at other active managers that target more specific outcomes that are aligned to yours.

Tracking error

An index fund won’t 100% replicate the performance of it’s underlying index (however it will get very close). This is mainly because of fees and transaction costs e.g. if an index fund charges 0.15%, you’d expect it to underperform the index by around 0.15%.

Transaction costs

This is more specific to ETF’s but each time you buy or sell an ETF you get charged brokerage so they might not be appropriate if your making smallish regular investments or need to make regular withdrawals. There’s also another cost called the buy/sell spread or just spread and this is a cost that’s relevant for index funds and active funds alike (spreads usually higher for active funds).

Next financial crisis?

Every now and then I’ll read an article (generally peddled by an active fund manager, go figure) that index funds and ETF’s, in particular, are becoming too big and could cause a stock market crash.

The argument is generally something like “index fund managers are just blindly investing the money they have come in into shares or divesting from shares to fund withdrawals and it’s pushing up share prices and there could be a liquidity issue if investors panic and withdraw at the same time”.

The counter arguments to this are:

  • Funds managed by index managers still make up a smallish % of the total stock exchange
  • Index funds have low turnover and make up a relatively small % of the overall trading volume
  • There’s no evidence to suggest that volatility has risen with the growth of index funds/ETF’s
  • The shares held by active funds aren’t that different to index funds so are still just as exposed to any crisis
  • With ETF’s, transactions are generally between buyers and sellers meaning there’s no requirement for another party to get involved and for the fund manager to buy/sell the underlying shares in the secondary market, therefore, it has no effect on the secondary market

ETF’s, in particular, have made investing more accessible so it is possible that this has allowed less experience and educated investors to enter the market after a good run (adding to the run) or leave the market when there’s a decline (adding to the decline) but this wouldn’t be a material proportion of the market.

In the past, constructing portfolios made up of “active fund managers” has been financial advisers bread and butter and they’d like to claim that they have superior skills to identify who the best managers are. I get it, this allows them to justify their fees and still happens today.

Fortunately, since fund managers have been banned from paying commissions to financial advisers since 2013 a lot of advisers now recommend index funds (no prizes for guessing a major reason why).

Although I’d be sceptical, I’m not definitively saying that you shouldn’t consider an active portfolio that a financial adviser has recommended to you (most large super funds still pay active managers) but I’d just ask more questions about the reasons why and their experience in successfully picking outperforming funds for clients over a long period of time before signing up to higher investment expenses (and generally another fee layer is required in the form of a “wrap platform” to access the active funds) and a strategy that is stacked against you.

Lastly, although I’ve mainly referred to share index funds in this post, the same principles apply index funds covering other asset classes e.g. property, fixed income, infrastructure etc..

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