Index funds have become popular of late. There's a good reason for that, but don't let their popularity cause you to get complacent.
Trends are so persnickety.
While we’re unlikely to see acid-washed jeans ever become a big thing again, you never know. I’d have said the same thing about bell-bottoms. But through all the fads, some of the basics stick, like Levi’s 5-pocket plain denim.
For investors, the index fund has become kind of like the Levi’s 5-pocket plain denim. They’re here, they’re solid (but not always spectacular), and they’re unlikely to be completely toppled from relevance, no matter what new trends—like robo-advisors—emerge.
So let’s talk a little about index funds, including their strengths and limitations. Index offer a (mostly) low-cost way for investors to track popular stock and bond market indexes. They 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.
Index funds are popular among dentists and other investors, and for good reason. These next three statements are all true: 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. (I know, I know, but this is finance we’re talking about!) 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. While those statements above are true, so are these next statements.
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.
If you’re a regular reader of this site, 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. Dentists generally find them of value because their income is relatively stable year over year; thus, their income cycle is a good fit for index funds. 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.