Index funds have been touted as a simple way to use a market or set of markets to generate financial growth. You’re supposed to free yourself from the handicap of actively managing your own portfolio by relying on a financial advisor and financial planners with the goal of playing the index instead of striving to pick stocks that outperform it.
Index funds might have a place in your asset management scheme, but there are several downsides to index funds that should prevent you from putting your entire retirement into an index fund.
Index funds are actually tied to the volatility of some stock rather than the index. New stocks that are performing well are added to the index, and stocks that are not performing well are removed from the index. This addition and loss usually occur once a year. If your asset management services don’t pay attention to individual stocks and how they trade, you’ll lose money when new stocks are added and underperforming ones are removed.
Although the idea of an index fund is to spread your risk across a variety of stocks and avoid losses, the reality is that the smaller the index your investment management planner has selected, the more likely you are to end up losing money. . In a small fund you really are putting all your eggs in one or two baskets. Those baskets are the few stocks that will make big gains in a year. If your fund is structured where you can’t get in and out quickly, you have a more than 50 percent chance of losing all the gains you made in the run-up when the few big players start to go under.
Another downside to index funds is that you don’t get the full advantage of the normal trading cycle. Every business has its ups and downs. Once a company leaves the fund it is in, it does not have the opportunity to benefit from the company’s turnaround if one occurs. Just think of the ups and downs Apple has experienced in the long run. You’ll have to wait up to a year to benefit from a returning artist who won’t be added to the index until a specific date.
Unless you enter or exit in March, when most funds are revalued, you may end up buying high and selling low on the few stocks that actually turn the index around.
The actions of an index fund manager make sense for the index fund. If a stock begins to underperform, the fund manager will lower the stock and sell the shares. This action drives the share price even lower and means that you lose more money if you are trapped in a bottom that does not allow you to get out quickly.
Index funds can also fall victim to timed electronic trading, also known as algorithmic trading. If a broker has inside information or just knowledge and knowledge of the market to see that one of your index fund stocks is going to go under, then they will dump all the stocks they own in one trade that takes microseconds. No financial advisor or money management service can operate at this rate. The end result is that you lose money because index funds simply cannot trade at the pace of e-traders.
You should remember that an index fund is a mutual fund and as such is subject to the tax liability and mismanagement that can occur with mutual funds.
Capital gains tax occurs regardless of the position of your funds in the market. You may find yourself in the position of losing most of what you earned in taxes if your index falls to a very low position just before you have to pay capital gains taxes. For large positions, this can happen four times a year.
Like all mutual funds, index funds charge fees. Fees, sales and administration charges can be as much as 1.2 percent of your portfolio at the time fees are accessed.
Index fund managers may engage in activities that benefit the fund rather than the investor. If a fund is taking a dip, a manager may be trading too often and too quickly in an effort to hit a predetermined quarterly target. This activity is usually not to your advantage. One sign of poor management is slow trade execution.
Part of the downside of index funds is the large reserve of cash the fund must maintain to cover withdrawals. This money does not generate money for you.
The number of funds and the indices to which the funds are linked can be a challenging choice for even the most experienced investor. There can be tracking errors that, while limited to five points, can be a big hit to your wallet.
Index funds are not all bad. You really need as many tips and information as possible to make money with the funds.
Your best bet for a portfolio that produces a comfortable retirement is diversification, advice from a proven financial advisor, and active involvement in how your money is working for you.
