A Look at the Benefits and Drawbacks of Investing in Index Funds

A Look at the Benefits and Drawbacks of Investing in Index Funds

The former president of DFC Global Corporation, Don Gayhardt serves as chief executive officer and president of CURO Financial Technologies Corp. Through CURO, Don Gayhardt provides short-term financial services to unbanked and underbanked individuals. He is also a member of the Community Financial Services Association of America board. Through these positions, he helps individuals reclaim control over their financial situations and work toward their personal goals. Once individuals have created a strategic plan for managing debt and begun to save money, they typically search out investment opportunities to help their money grow. An investment option that many individuals in this situation choose is the mutual fund, which mitigates some of the risk of investing in a single stock.

A popular type of mutual fund remains the index fund. Last year, an estimated 20 percent of all money invested in American equity markets was placed in index funds. These mutual funds are tied to the performance of an index, such as the Dow Jones Industrial Average or the S&P 500. An index is simply a collection of stocks that are chosen according to a specific rubric. Importantly, the criteria for inclusion of a stock on a particular index can change over time. While a typical mutual fund has a portfolio manager that ultimately makes selections, an index fund uses the criteria of a particular index. In other words, the people behind the index have ultimate responsibility for the investment of the money.

Why Does It Make Sense to Invest in an Index Fund?

investmentsInvesting in an index fund has a number of benefits, especially for people who have less money to invest. One of the biggest benefits is a lower expense ratio. Many mutual funds will not accept investments below an arbitrary threshold or may charge large investment management fees to do so. These fees cut seriously into the returns from the investment. An average expense ratio for a large-company stock mutual fund is over 1.1 percent, but index funds charge less than 0.5 percent on average, and some options are much less than that.

Another benefit of investing in an index fund comes from low turnover rates. Generally, index funds operate in a passive manner, which a great deal of research has shown to be an effective approach. Despite this, human-directed funds tend to have much higher turnover rates, which can limit the fund’s returns and also rack up a great deal of transactions costs that further lessen returns.

Index funds also come with the benefits of the larger category of mutual funds. Namely, individuals can diversify their investment to protect against loss without purchasing a number of different securities. Buying into an index funds means investing in the larger industry that the index represents, whether that is large companies, utilities, or something else entirely. This allows individuals to avoid the need to value businesses and instead leave the decisions to a proven algorithm.

What Do Investors Need to Look out For?

Of course, investing in an index fund is not without risk. Any investment involves some degree of exposure. One of the biggest concerns with index funds is that the past will not actually repeat itself. Historically, index funds have provided individuals who have less money to invest with a way to diversify and benefit from long-term holdings, but this may not always be the case. For many index funds, the algorithms that go into choosing stocks changes, and these shifts may not always be for the best.

Another consideration is that the performance of an index fund is only as good as the performance of the index itself. Not all indexes are created equal, and some produce fairly mediocre returns. For this reason, investors still need to perform some due diligence before making a final decision. However, even funds that have historically performed well, such as the S&P 500, have no guarantee of continuing this record into the future.

Investors also need to keep in mind that indexes may not be representative of different industries. While some indexes are tied to a specific industry, many are not. The S&P 500’s current manifestation has actually received considerable criticism for including too many financial companies, which inhibits diversity and can lead to issues for investors if the financial industry takes a major hit. Because index funds are tied to the index itself, individual investors have no control over how their money is actually allocated. Again, investors simply need to look at the different indexes and figure out which ones they think provide the greatest potential for future gains.

As individual investors become more comfortable with the process and begin to have more money to invest, they should consider another drawback of index funds—namely, that it basically piggybacks off of what other buyers and sellers are doing in the market. In other words, investing in an index fund does not provide the same economic stimulus that buying a stock outright would. Index funds remain a great option for people who want a relatively safe investment, but investors who have more capitalistic goals will want to seek out different options.