The popularity of investing in index funds has been gaining interest in recent years. Index mutual funds are not a new concept – they have been available for over four decades, and exchange-traded funds (“ETF”) for more than ten years. What has changed is the number of investors putting money into these funds, which has been steadily increasing as people look for an inexpensive way to invest in the markets without having to actively manage a large portfolio of individual stocks.
There are some benefits to investing in index funds but there are also some misconceptions that you should be aware of. We will break down some of the more important factors you should know to help you make a decision about how to invest for your future.
What are Index Funds?
Like traditional mutual funds, index funds are a basket of different investments, such as stocks. What makes an index fund different is that instead of being actively managed, it is considered “passive .” Let’s look at the S&P 500 as an example. This index tracks the stocks of 500 large-cap U.S. companies. If you want your portfolio to reflect the performance of this index, you have two options. First, you can construct a portfolio of these individual stocks with the appropriate weightings. This means buying shares of 500 different companies and updating the portfolio as changes are made to the index. The second option is to buy shares of an index fund that tracks the S&P 500. Therein lies the appeal of index funds. They offer investors a simpler way to track popular indexes and quickly diversify their portfolio with a number of different stocks.
Now that you have a basic understanding, here are a few things to know before investing in index funds.
1. Index Funds May Not be Safer Than Other Investments
A common misconception about investing in index funds is that they are less volatile than other investment options. While this can be true when compared to a portfolio that holds a limited number of stocks, index funds can experience similarly volatile gains and losses as their actively managed counterparts. While diversification can reduce some forms of risk in a portfolio, it cannot remove risk completely.
2. Index Funds are Not Always Less Costly
Many investors are drawn to investing in index funds because of low management fees. These management fees can be markedly lower than those of actively managed mutual funds and, on the surface, may seem more attractive to fee-conscious investors that want to hold on to more of their returns. However, a management fee only tells part of the story.
While investors don’t have to actively participate in reallocating the assets of the index fund they have chosen, the fund manager must still take on this task. If an index changes which assets it’s tracking, the fund must sell and/or buy assets to ensure its holdings are reflective of that index. Not only can this accrue fees for the fund (which are passed on to investors), it can also result in the fund manager being forced to “sell low” to continue tracking the index.
For example, in January 2019, Teleflex (ticker: TFX) was added to the S&P 500 Index and PG&E Corp. (ticker: PCG) was removed due to the latter filing for bankruptcy. Both stocks experienced higher than normal trading levels around that time as the demand for Teleflex shares increased and the demand for PG&E shares fell. Therefore, the fund manager would have had to sell PG&E shares when it was trading at a lower price and purchase Teleflex shares when it was trading at a higher price, which would have been opposite of the “buy low, sell high” goal when investing .
3. A Fund’s Benchmark is Not a Guarantee
When you buy shares of a mutual fund that is designed to track a specific index, you may expect that the results your fund delivers will be consistent with the index it is tracking. However, this is not the case. The main reason for this is fees. Because you cannot invest directly in an index (which has no fees), you must invest in a mutual fund or exchanged-traded fund, both of which have fees and expenses that are passed on to the investor. While these fees may be lower than many traditional mutual funds, they can add up quickly. Because of these fees, it is common for an index fund’s performance to lag behind that of the index it is tracking.
4. An Index Fund is not the Key to Success
Some investors incorrectly assume that investing in index funds and then sitting back until retirement is the key to investment success. While it is important to keep long term goals in mind and avoid short term emotional decisions when investing, index funds are not the simple solution to investing success. Rather, they are one tool in the toolbox for investors to use when planning for the future.
Whether you choose to buy index funds or go for a more active approach, there are many other key concepts and considerations that you should keep in mind. For example, considering your appetite for risk and setting a realistic time horizon to meet your investment goals are both important aspects of investing. They don’t become any more or less important simply because you have chosen to buy index funds.
Use All of the Tools Available to You
Index funds are just one tool in the toolkit when it comes to investing. They are not inherently good or bad. They could be an important part of your overall portfolio; however, there is much more to consider beyond just what assets you will hold in your portfolio. Other things, like retirement planning, tax planning, and estate planning, are all part of the overall financial picture. Before you make any investment, whether in an index fund or something else, you need to have a clear financial plan that meets your unique goals. That’s where our team of CERTIFIED FINANCIAL PLANNER™ professionals step in, to help our client families navigate the changes in their lives and in the investment world.
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