One of the most prominent of passive investment strategies is the investment strategy adopted by an index fund. In this strategy the fund would mimic an index, meaning that it will include in it all the stocks that are represented on a stock index and in the same proportions. While these funds will generate a return that is almost similar the index, the rational behind investing in these index funds is that they charge minimal to no investment management fees, where as an actively managed fund would charge a management fee which would eat into the gains made by the fund and its absolute returns may very well be less than the returns generated by an index fund. In the long run also, it has been observed that the performance of actively managed funds even out and tend to be on the same lines as that of indexed funds. Index funds thus try to outperform actively managed funds by being more efficient rather than employing high cost fund management professionals and using advanced analytical and computational tools.
The distinguishing feature of index funds is their passive management and the consequent low operating costs. The only operations carried out by fund managers are those required to preserve the appropriate portfolio structure. This means they only purchase securities which are added to the index or sell those which drop out. Introduced first in 1971 by the Wells Fargo Bank in the United States, these funds can be of two types, Exchange Traded Fund (ETF) index funds and Mutual fund type index funds. Other than the lower cost of management, the other advantages of index funds is its simplicity in choosing of stocks and measuring the performance of the fund, no change in styles as against an active fund where a fund manager may change his focus to suit his objectives which make is difficult for the investors to track and very low turnover compared to an actively managed portfolio. A lower turnover not only brings down the transaction cost significantly but also entails significant tax benefits for the investor investing in the units of an indexed fund. Index funds also act as great preservers of capital, walking with the index ensures that good performing stocks are automatically included and poor performing stocks are automatically discarded over a period of time, with all the research work done by the Index maintaining company with no cost incidence on the Fund company or the investors. The risk associated with the index fund is also very low as it entails close to zero unsystematic risk as we are following a broader equity index itself.
However, there are a number of other reasons as well why one should avoid investing in an indexed fund. Below are described five important reasons.
- Index funds are lost opportunity at least in the short run – Actively managed funds are good performers in the short run, especially during periods of economic booms, their performance outperforms every other form of investment strategy. An investor, if he is able to time himself right, he can benefit immensely by investing in an actively managed fund, while an index fund investor will only moderately benefit from the bull run.
- Styled index funds don’t offer full diversification benefits – A styled index fund or a focused fund such as a bio-tech sector focused fund or an infrastructure sector focused fund are very much susceptible to the risks associated with such sectors. Unlike an actively managed fund which would take corrective risk management measures, passive funds would only try to wait out the adversity so that they may start making money again.
- Arbitrage losses – An index fund must rebalance periodically in order to incorporate the changes that may have come about in the index. This rebalancing may happen quarterly or semi-annually as the case may be. It is thus fairly easy for arbitrage opportunity seekers to anticipate in advance which stocks are going to be included in an indexed fund during their next round of rebalancing. These arbitrage seekers would then buy these stocks in advance so that when there is a sudden demand shock when an index funds enter the market the prices will jack up and they will make a quick buck. These arbitragers cause significant opportunity capital losses to the index funds and make them expensive and lower their yields. Whereas, an actively managed fund would most often be the arbitrage opportunity availing entity and would benefit at the expense of the passively managed index fund.
- Large amount of money chasing a single index – Another very peculiar problem happens when too many funds track a single index. Now each of these funds has a significant corpus with themselves and create demand and supply shocks in the marketplace whenever they try to rebalance. The fund which rebalances first thus creates a significant adverse situation for the funds which are going to follow suit. The problem is especially exacerbated when the index fund as a matter of policy cannot time itself to avoid such pitfalls and must rebalance as per its schedule.
- The Tracking error effect – A tracking error tracks or records how efficiently a fund is able to mimic its chosen index fund. Since an index fund tries to mimic the performance of an index, theoretically it will be performing better if it has a positive tracking error. However, this can be deceiving for an investor if he were to take it as a performance parameter of the fund, because when the index itself is underperforming, the fund would obviously under perform as a consequence on an absolute scale.
Other than the above five reasons there are many other reasons that can be sighted why an index fund should be avoided. However, investment in an index fund is more about the objective one seeks other than that of stable returns due to which these funds have gained so much popularity. These funds are usually preferred by highly risk averse investors and are avoided by those who are seeking active management.
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