Anybody offering sound investing advice will encourage you to build a diversified portfolio where you invest in multiple companies to minimize your risk of losing everything in a stock market correction. For the past two decades, index funds have been one of the most popular recommendations because of their low management fees and instant diversification. It’s hard to argue against these two benefits but should you avoid index funds?
Index funds are a good idea and can certainly be an easy and affordable way to gain exposure to the broad market, but they shouldn’t be your only investment choice for the following reasons.
Index Funds Never Beat the Market
People think index funds are good because they outperform actively managed funds 60% of the time which means you can make more money long-term in a positive market. Even if an index fund and an active fund produce the same return for the year, you might still collect a larger dividend with the index fund because the fund expenses are lower because they only try to match the performance of the market they are tracking.
For example, an S&P 500 index fund wants to track the actual return of the S&P 500. In 2017, for example, the S&P 500 index returned 21.83%
How did two of the index funds compare?
- Vanguard S&P 500 ETF (VOO): 17.08%
- SPRD S&P 500 ETF (SPY): 17.11%
These returns are excellent, but how did the actively managed S&P 500 ETFs do?
- Guggenheim S&P 500 Equal Weight ETF (RSP): 12.42%
- Guggenheim S&P 500 Top 50 ETF (XLG): 19.23%
- PowerShares Low Volatility S&P 500 (SPLV): 9.36%
As you can see, only one of the funds outperformed the passive income funds during the same time period.
But, the reason you might consider adding at least one actively managed ETF or mutual fund to your portfolio is that active funds can do better in volatile times compared to index funds.
For example, when the broad market dips or corrects, you know that your index fund will decline proportionally.
In other words, you’re guaranteed to lose money.
If you choose the right active fund, you can actually gain money in a down market or at least minimize your losses. Active funds are more appealing than index funds in uncertain investing times because of these reasons.
Active Funds and Individual Stocks Add Diversification
With an index fund, your portfolio performance is solely dictated by the performance of the index your index fund tracks. That can be the S&P 500, Russell 2000, or the FTSE for example.
Actively managed funds can outperform the index because they invest in undervalued stocks that index funds only have a small position in. When that stock becomes overbought or the market fundamentals change, the fund manager can sell that particular stock and buy a different prospect. That’s not the case with an index fund where it keeps the same portfolio allocation as long as it’s in the index.
If you need ideas of what funds to invest in, consider subscribing to Kiplinger’s Personal Finance for $12 a year or joining an online investing group for more information. You can also subscribe to an investing newsletter but research online reviews before you join as some newsletters are better than others. And, investing newsletters can cost between $100 and $5,000 a year so you need to be able to earn enough in stock appreciation and dividends to recoup your subscription cost and profit.
These funds are more “hands-on” but adding a few positions can increase your income potential. But, you need to pay attention to price movements and not be afraid to cut your losses if the stock ends up underwhelming or the company fundamentals change for the worse. You still need to have a plan when investing in an index fund, but it can be even more important with active funds.
You Can’t Choose Your Investments
Besides only mirroring the broad market’s performance, you can’t choose which investments are in an index fund. You might oppose certain companies in the S&P 500 index because you don’t agree with their company platform. For example, they might sell tobacco, alcohol, or firearms and you know that investing in their company gives them more capital to grow their business.
By investing in socially-conscious funds or picking your own stocks, you can choose to not invest in companies that index funds are required to invest in to accurately track the index. Depending on the business, this can potentially help or harm your overall portfolio performance.
If you don’t have the time to vet each individual company, you can also invest with Swell Investing, a robo-advisor that lets you invest in socially-responsible portfolios. Some of the funds in the Swell portfolio have actually outperformed the S&P 500 index which means you can invest with a mission and still make more money than simply tracking the broad market.
Should You Avoid Index Funds?
Index funds have a definite purpose in the investing world. Since most active managers cannot consistently outperform the market, index funds are the closest alternative to consistently providing the highest return with the lowest fees. Investors with no knowledge can successfully invest thanks to index funds, but you limit your potential by only owning index funds and not adding at least one individual stock or active ETF to your portfolio. Diversifying away from index funds can help protect you during a market downturn and potentially increase your earnings during bull markets too.
Not every active fund or stock is a good investment option, but not every index fund is either. Like any investment, there are risks for every investment including index funds. Trying something new, even with a small portion of your portfolio can be well worth it.