5 Reasons To Avoid Index Funds?
Posted: June 9th, 2009 | Author: Joe | Filed under: Investing | Tags: index funds, Investing, Stock Market, Stocks | 4 Comments »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 index funds?
Here’s a break down of the list of why you should avoid index funds and along with my problem with each item.
5 reasons to avoid index funds
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“
I can’t really argue too much with the first part, but is that a reason to avoid index funds?
It’s the second part (in bold) that goes off the rails for me. 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! Again, not really a reason to avoid index funds.
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. This is a lot like saying people should avoid index funds because they aren’t individual stocks. ANd what about mutual funds in general? Investors have no control over their individual holding either. Should people avoid mutual funds too?
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. If you’re looking to run your own portfolio, then do it. This isn’t a reason to avoid index funds if you’re looking for a simple, passive portfolio.
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. Instead, the article seems to imply that all investors should avoid index funds, regardless of their goals and style.
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 – leave active investing to the pros, and don’t avoid index funds.
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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