In 2012, index funds accounted for 24% of assets under management, growing four times faster than all other funds, according to Morningstar. A major draw to index funds is their low expense ratios. Index funds typically have low expense ratios because they track and invest in a particular index. This framework however results in the major flaw of index funds.
Index funds attempt to minimize tracking error by holding whatever stocks comprise the index they track at that moment. The companies that construct the index determine when the companies in an index change, in addition to setting the parameters of inclusion for the index. This provides a model which determines the timeliness which stocks are included in that index and which stocks get removed from that index. If you run an index fund and you want to minimize tracking error, you have to buy and sell along with everyone else in the open market when the index constituents change. For example, if you are running an index fund, when stock XYZ is added to the index and stock ABC is dropped from the index, you buy stock XYZ and sell stock ABC. If other index fund companies are doing the exact same thing, what do you think this does to the prices of these two stocks? Stock XYZ’s price is bid up and Stock ABC’s price is bid down.
Some fund companies like Dimensional Funds, do not tie their funds to any indexes to avoid buying and selling when there is higher than usual volume for funds being added/removed from an index. Dimensional Funds has found that they can exploit this conception known as ‘mis-pricing’ by waiting to buy XYZ and waiting to sell ABC for a few days, weeks or months – waiting to buy/sell those particular stocks until after everyone else is done trading in the stocks that were added and dropped from the index. Dimensional Funds can sometimes outperform an index by not buying and selling when everyone is adjusting their holdings to reflect the changes to an index fund.
Another problem with index funds is they don’t maintain consistent exposure to an asset class as a result of the stocks in the index changing in size throughout the year and because an index may only change its holdings once per year. Therefore, your index fund can start the year as a small cap fund and drift to a mid-cap index fund as the stocks in the index increase in value, changing your portfolio’s allocation during the year.
In addition to the mis-pricing that can occur, another issue that faces certain indexes is that some indexes can change 25% of their stocks in one year, making turnover a major problem. Higher turnover can result in more capital gains and lower tax efficiency in a tax year. Additional capital gains are not always ideal for an investor.
When deciding whether or not an index fund is the right investment for your portfolio, it is important that you fully understand the index fund’s investment strategy and philosophy. Failure to do so could result in lower returns, unexpected capital gain distributions, an overweighted investment portfolio in a certain asset class, etc. It is important to consult with your wealth advisor and accountant when making investment decisions to ensure your investment portfolio best suits your current situation, your goals and your risk tolerance.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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