I just saw an interesting article on Investopedia.com titled, “5 Reasons To Avoid Index Funds” Well, I thought it was interesting because of the title. Much of the blogosphere and many professional investors recommend index funds for the average investor, so why avoid them?
Here’s a break down of the list and along with my problem with each item.
1. Lack of Downside Protection
“Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside. You can choose to hedge your exposure to the index by shorting the index, or buying a put against the index”
OK, I can’t really argue too much with part, but the second part (in bold) goes off the rails. If you’re hedging with an index fund using puts and calls, then you’re not really using the index fund for what it was designed for anyway. The point is that index investing is simple, and doesn’t require some esoteric wall street mumbo jumbo.
Besides, there’s an easier way to limit the downside. Using stop loss and market orders you could buy index fund ETF’s and avoid much of the carnage caused in wall street last fall.
2. Lack of Reactive Ability
“[a] sector may be a compelling value, but in a broad market value weighted index, exposure to that sector will actually be reduced instead of increased. Active management can take advantage of this misguided behavior in the market.”
This sounds a lot like “index investing doesn’t let you actively manage the fund”. I mean, that’s true, but it’s also the point of an index fund!
3. No Control Over Holdings
“If an investor buys an index fund, he or she has no control over the individual holdings in the portfolio.”
Yup. That’s the point.
4. Limited Exposure to Different Strategies
“If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. After you’ve done the research, you can combine them into a smaller, more targeted portfolio. You may be able to provide yourself with a better-positioned portfolio than the overall market,”
Again, index investing doesn’t allow you to actively manage the index.
5. Dampened Personal Satisfaction
“…you will lose the satisfaction and excitement of making good investments and being successful with your money”
If you’re an investor and you’re looking for the thrill of trading stocks, you’re not going to be investing in an index fund.
The problem here seems to be a misunderstanding of index investing. Maybe the writer is too close to wall street and caught up in that atmosphere. I dunno. The point of the article should be why you might want to invest in an index fund, and when you wouldn’t.
Index investing should not and cannot replace active investing as many have implied. Index investing is a passive method for people who either can’t fathom stock investing or choose not to expend the time and effort required to take part in the stock market actively. This is the same position espoused by the likes of Warren Buffet and Jim Cramer.
Good counterpoints. I can see that clearly even though I have limited understanding how these things work.
Stock investing is something I’m looking at to probably do in the future. Thus, it helps to read posts like this which can prepare me for that future.
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