Index-related Risks and Features

logo  21 December 2022

Index funds are popular because they are a low-risk, low-maintenance, and inexpensive way to generate consistent returns over time. Such investments, however, are not suitable for everyone. Index funds are best utilized by investors with long-term goals: although the market has historically risen over time, you really need a lot of time, and a margin of safety to take a few hits.

Index funds

Index funds are ideal for those who are not interested in picking stocks and do not seek a quick profit. Index funds usually perform better than actively managed funds over time and typically yield moderate returns. In contrast, actively managed funds can sometimes produce higher revenue over a short period of time. Any investment, of course, involves risks, but index funds rank fairly low on that spectrum, and they are certainly more profitable than trying to buy stocks on their own. Many investors simply cannot afford to make excessive bets on individual securities, in which case investing in a broadly diversified basket is a smarter strategy.

This method has its pros and cons, and it is best to know them in advance before you build an investment portfolio.

Pros:

  • Affordability — stocks and some ETF units cost relatively little money;
  • Diversification — funds may be used to form a portfolio, allocating assets to different countries, markets, currencies, and instruments;
  • Minimum analysis requirement — no need to spend time and money for studying technical and fundamental analysis, monitoring markets, or keeping tabs on expert reports;
  • Composition transparency — an index is always open for review, with comprehensive information about it available to the public;
  • High liquidity — the stock market always has numerous buyers and sellers, so you can make a deal almost instantly;
  • Tax privileges — there is an option to purchase shares, and long-term ownership privilege are very enticing.

Index fund disadvantages

ETFs rise and fall along with the index on which they are built. This is an inherent disadvantage of all passive management funds. Asset diversification is not always a plus, either. A broad set of assets leads to a smaller average market growth, while an actively managed fund is more flexible to adjust to market fluctuations.

Do not wait for short-term gains

Diversification strategy limits your losses if one stock fails, but it also curtails your opportunities to profit on stocks that are performing well. That is why index funds do not see the big rises that some investors hope for. If you want to speculate on skyrocketing profits, you will need a different type of product, such as smaller stocks.

Vulnerability in the eye of the market

Index funds are tied to their index. If the benchmark falls, so will the value of your index fund investment. Index portfolio managers usually ca not deviate from index assets, even if that would allow them to take advantage of trends or market missteps, nor can they rule out overvalued assets.

Index investment is not really passive

It is actually only passive for you as an investor, since you do not pick stocks and buy fund units that come with many stocks included in the index in varying proportions. Indexing itself, however, is an active strategy that involves selecting specific stocks to be included in the index according to certain criteria, establishing a share, and periodically buying and selling them.

Buying an ETF does not make you share-eligible

All shares are registered with the fund’s management company that keeps a shareholder register. Your broker will be on that list, and they will already have your name in their records. Of course, there are a lot of mechanisms in the U.S. for protecting the rights of those shareholders who happen to be U.S. citizens, but they might not even work if, for example, the market got in a big mess, like the repeat of the 1930s’ Great Depression, or if the investor is a foreigner.

Before you invest in index funds…

Before considering an index fund, you should read the fund’s prospectus to understand which index it follows. There are many different stock indices, and some funds use a mix of them. Also check how much the fund actually follows the index. True index funds follow the index to the “T,” but some allow portfolio managers to deviate from the index in an attempt to boost their returns.

Pay attention to the fund’s fee-to-cost ratio. It is usually low, but can be higher in funds where the portfolio manager is allowed to trade more actively.

When choosing a stock market investment fund, it is advisable to research it thoroughly in order to understand how its prospects match your investment strategy. Before you buy, you need to see how profitable it can be and how long you can even hold such assets. With a diversified portfolio already in place, there can be excellent long-term investment opportunities afoot.

When investing long-term, one should choose from the list of the most stable funds. These are called passive funds because they are completely dependent on already existing indices or other ready-made portfolios. Another of their differences from active funds is that they never shuffle their portfolios.

It can be concluded that passive investing suits the vast majority of investors who plan to keep their capital for years to come and multiply it by a percentage much higher than the current inflation rate.

Looking at the changes in any index during the past 10–15 years, we will find that it pretty much always grows. There are sharp ups and downs at certain periods of time, but the overall trend is always going upwards. If trading is not your profession or even hobby you would like to engage in regularly, there is no better alternative than index investment.