Index funds have exploded in popularity among investors in the last two decades. These passive instruments are now designed to track the largest markets as well as small segments within them. The companies specializing in creating and managing these funds have attracted trillions of dollars in investments into this relatively new financial product because there are some clear advantages when compared to other investment vehicles, however there are some possible downsides that investors must be cautious of.
The Pros of Index Funds
1. Less Expensive
Because index funds are designed to track a basket of assets, the management fees attached to this investment are far lower than other alternatives. The annual cost of owning an index fund is usually less than one percent of the overall investment compared with large annual fees charged by hedge funds and other financial advisors.
Financial advisors recommend a well balanced portfolio to avoid over exposure to a particular stock or sector. It can be expensive for an ordinary investor to accumulate shares in many different companies but index funds solve this problem by allowing individuals to purchase a basket of different stocks for a far lower price.
Many ordinary investors as well as high priced asset managers believe they can outsmart the market consistently. Unfortunately, its almost impossible to over the long term. One of the principles of modern economics is that public markets are the most efficient way to price an asset in real real time, incorporating all available information. This theory has been demonstrated over time and index funds take advantage of this by tracking the performance of the market or a sector as a whole rather than relying on individual judgment.
The Cons of Index Funds
Because the assets behind index funds are frequently changing and there are not uniform reporting standards, it is far more difficult for an investor to determine exactly what they own than if they purchased a share of an individual corporations. This is particularly important for investors focused on corporate responsibility or impact investing.
2. No Upside
Despite the difficulty in achieving constant returns over the long term, many investors and actively managed funds are able to outperform the market overall. Index funds remove this possibility, however remote, by tracking market performance rather than exceeding it.
3. Unknown Management
Trusting your hard earned money with someone takes a lot of trust, which is why many investors prefer to have a personal relationship with their asset manager. Index funds still rely on management but the individual investor will never know the people who are performing the operations behind the scenes.