The Disadvantages of Index Funds


There is no such thing as a perfect investment. Even index funds have downsides, though few are deal-breakers. Here’s what to consider when choosing an index fund and some reasons to consider ETFs.

At risk of sounding like a broken record, I’ll say it again: index mutual funds have revolutionized the financial industry and rightly so. When compared to active mutual funds, index funds raise investor returns while also reducing costs and risk.

But they’re not a panacea. If they were, everyone’s portfolio would consist solely of a handful of index funds and the financial services industry would be much smaller than it is today. Like any financial product, index fund investing carries risk and possibly deal-breaking defects.

In this article, I run through some of the factors you should consider when deciding whether index funds are consistent with your investment objectives and, if they are, the criteria that you should use when choosing an index fund.

Even for those of you already committed to indexing (I fall into this group), it’s important to be aware of the possible inefficiencies of an index fund. The index fund industry isn’t a monolith, and hence there’s value in being able to identify the disadvantages of index funds you’re researching.

With the information in this article, you’ll be able to differentiate the well-managed index fund from the train wreck fund that will dampen your portfolio’s performance. Or you may, as I’m considering, defect from index funds to another means of indexing, ETFs (exchange-traded funds).

Let’s jump in.

Investment objectives

Passive investing isn’t the right investment strategy for everyone. Before you invest in an index fund, or anything for that matter, you need to have a clear understanding of your investment objectives and which assets yield returns consistent with them.

Imagine an early career lawyer, Sally, interested in aggressively growing her retirement nest egg. Sally has always associated bonds with retirement and decides to build her retirement portfolio entirely out of treasury bonds.

Unsurprisingly, she becomes upset when she realizes her long-term returns are significantly lower than those of her friend’s portfolio containing only stocks. This isn’t a fault in the treasuries she invested in; there’re many situations where treasuries are the correct investment approach. The fault instead lies in Sally’s failure to choose an asset consistent with her investment objectives.

Not doing your due diligence before investing in index funds can put you in the same position as Sally. While certainly not as conservative as treasuries, index returns won’t be the highest possible. The diversified nature of index funds shelters you from the volatility of an individual stock or bond, but this added safety costs you the possibility of triple digit annual returns that many investors chase. (You probably don’t want to chase higher returns anyway; it’s more than likely a fool’s errand.)

Though index funds are low-risk compared to individual securities, they’re by no means riskless. Diversification can only protect you so much. An index fund allows you to own a little bit of every stock or bond in an index, but if a recession hits and market returns disappear, you’ll experience significant losses.

Once you articulate your investment objectives and decide that index funds are consistent with them, you’re not done with your research yet, although many investors make the mistake of stopping here. People often conflate all index funds with total stock market index funds like Vanguard’s VTSAX. Such funds are common but by no means the only type of fund out there.

Index funds exist to track any asset class in any market imaginable. You can find funds that track an index of treasuries or junk bonds; precious metals or real estate; or small cap, mid cap, and large cap American companies. The possibilities are nearly endless. Each type comes with a unique blend of possible risk and return. You’ll need to choose those which are consistent with your investment objectives.

Only after selecting a benchmark that you want to track are you faced with the final hurdle of choosing the correct index fund provider. When you are, for example, looking for an S&P 500 index fund, you’ll discover a variety of providers, each offering their own stock index funds.

It’s at this level of your decision that the actual defects of different providers’ index funds—fees, tracking errors, tax efficiency—need to be considered.

Fees

Costs matter. Warren Buffet knows it. Jack Bogle, founder of Vanguard, knows it. You should know it, too.

Fees should be at the forefront of your mind whenever you’re analyzing a potential investment. A fund’s impressive nominal returns mean nothing if, after management fees, the fund’s net return is below that of competitor funds.

Fortunately, decades of fierce competition in the index fund industry have forced the major providers to offer rock bottom fees (usually four or five basis points for liquid US assets). Still, however, there are oddball funds, even from reputable companies such as Wells Fargo, that have expense ratios well over one percent. Avoid these. There are no good reasons to pay such high fees for an index fund.

Even when deciding between two funds with low costs, you shouldn’t ignore the difference a few basis points make. When the spread in expense ratios between two funds gets down to a basis point or two, sure, you can feel comfortable ignoring the difference.

But the difference between the returns of a 0.14% expense ratio fund (the average fee of an Admiral class Vanguard fund) and a 0.27% fund (the average fee of an Investor class Vanguard fund) warrants attention. A 13 basis point spread, when compound interest is accounted for, quickly shrinks your returns by thousands of dollars even on a fairly small initial investment.

You’d never leave a hundred dollars lying on the sidewalk. It shouldn’t be any different when investing.

Interesting side note: Fidelity now offers a zero-fee index fund. This beats even major players like Vanguard’s Admiral class of funds. Though zero fees certainly sounds impressive, don’t let it blind you. All the factors discussed in this article should play a role in your investment decision. Milton Friedman’s famous adage rings true here: There’s no such thing as a free lunch. Check out this article on why the Fidelity zero-fee funds might not be the best option for you.

Tracking errors

Portfolio managers of index fund’s don’t actively pick assets, but this doesn’t mean management doesn’t play a key role in index fund performance.

Someone needs to keep the fund in line with the underlying index, and that responsibility falls upon the manager. This can be enormously technical, and a clever manager has the opportunity to make decisions that both minimize expenses and keep a fund’s tracking error low.

An incompetent manager, however, can generate tracking errors just as easily as a talented one can reduce them. These errors appear for a variety of reasons like maintaining holdings unrepresentative of the underlying index or insufficient cash for fulfilling redemptions. Whatever the reason may be, the end result is the same: deviations (usually negative) from the return of the tracked index.

Before purchasing an index fund, you’ll want to check the fund’s historical performance for deviations from its corresponding benchmark. A fund that consistently deviates from the index it mirrors, even when this deviation increases returns, should be avoided.

Negative deviations are obviously undesirable. The fund flat out underperformed the index. More subtly though, positive deviations are also undesirable. Such deviations occur because a manager either doesn’t have the knowledge or the capital to track the index precisely.

This time you lucked into better returns; you won’t be so lucky in the long term. Jump ship to a better managed fund. There are plenty of index funds with talented managers and boatloads of capital that consistently track their target indexes.

Tax efficiency

While index funds have less turnover in holdings than their actively managed counterparts, an appreciable amount of turnover still occurs. That means you’ll need to worry about the most glamorous part of investing: taxes.

Index funds can generate taxable events in two ways: the first, when a fund distributes earnings (from dividends, for example), regardless of whether these earnings are reinvested into the fund or paid out in cash; and the second, when a fund sells assets.

If you hold your index funds in a taxable account, you’ll need to pay taxes on distributed earnings every April. You’ll pay your tax bracket’s long-term capital gains rate, which is more favorable than your income tax rate but still isn’t cheap. Anyone investing in taxable accounts, therefore, should pay especially close attention to their index fund’s tax efficiency.

For those investors who instead hold their index funds in a tax-advantaged retirement account, such as a 401(k)s and  Roth IRAs, you won’t need to worry about paying these taxes directly.

This doesn’t, however, mean you should ignore a fund’s tax efficiency. Even if you’re not the one footing the tax bill, the fund still needs to pay taxes every time turnover occurs. And whenever taxes are paid, that means money is transferred out of the fund and into the IRS’s bank account. Less money in the fund means the cost of a share of the fund goes down, creating a drag on fund investors’ returns.

ETFs

While well managed index funds do a good job of mitigating the impact of fees, taxes, and tracking errors, ETFs make a strong case for better managing these issues.

ETFs are essentially publicly traded index funds. That means they’re listed to an exchange and investors can buy and sell shares of an ETF with any brokerage account. This may seem a minor difference, but it has important implications for the performance of ETFs.

ETFs consistently have lower expense ratios than index funds with similar holdings. This is largely due to how shares of ETFs are redeemed. Unlike index funds, investors trade ETFs on an exchange instead of turning them in to a manager for cash. This means a buyer directly provides cash to an independent seller, saving the fund’s managers from needing to have cash on hand for redemptions or, worse, having to liquidate assets to pay investors. These savings are then passed on to the investor in the form of lower expenses.

ETFs are also more tax efficient than index funds. Generally, an ETF with the same holdings as an index fund will generate fewer taxable events due to a backend feature governing how institutional investors redeem shares (i.e., in-kind redemptions). Fewer redemptions means lower turnover of fund assets and, consequently, fewer taxable events.

Tracking errors, however, remain an issue with ETFs, especially those tracking more niche indexes. Opening the fund to public trading does nothing to lessen this issue.

There’s also a grab bag of minor advantages ETFs offer that index funds don’t. Unlike index funds, you don’t need an account with an ETFs provider to purchase shares; you can use any brokerage account you’d like. ETFs also require a smaller minimum investment. Shares of ETFs can be purchased for a couple hundred dollars or less, while index funds usually require an initial investment of thousands of dollars if you want access to competitive expense ratios.

Check out this article for a more in-depth comparison of index funds and ETFs.

That’s all, folks

That’s all for the basic factors you should have in mind when deciding if a particular index fund is right for you.

Again, these considerations aren’t meant to discourage you from purchasing index funds, only to make you aware of some important factors you should consider before investing. There are many advantages of index funds. The more you know, though, the better you’ll be able to choose the fund that’s right for you.

I’ve made no effort to compare specific index funds. Using the decision-making outline in this article, you can now check out reports from rating agencies like Morning Star and Moody’s for fund specific info.

What do you think? Are index funds for you? How about ETFs? If you research individual providers, let me know in the comments.

Joseph Parise

Joseph Parise A junior at the University of Buffalo, Joseph grew up in New York and is majoring in Philosophy and Economics. He is currently taking a gap year to study for the LSAT exam and to serve in the US Air Force Reserves.

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