Investing in index mutual funds and ETFs gets a lot of positive press, and truly so. Index funds, at their best, offer a low-cost way for investors to track popular stock and bond market indexes. In many cases index funds outperform the majority of actively managed mutual funds.
One might think investing in index products is easy. However, the providers of mutual funds and exchange-traded funds (ETFs) have created a slew of new index products in response to the popularity of index investing. Here are some things to know about index funds as you plan your investment strategy.
1. NotAll Index Funds are Cheap
If your 401(k) plan contains index funds from providers such as Vanguard Group or Fidelity Investments, you can be pretty certain these are low cost. Many 401(k) plans, unfortunately, do not offer index funds that are not this cheap. This may be true if your plan provider is an insurance company or brokerage firm offering their own proprietary funds.
While the advice to focus on index funds in your 401(k) plan is often sound, make sure that you look at the index funds offered in your plan to ensure that you are making the best choices. For 401(k) participant’s fortunate enough to have a selection of several low-cost index funds, the advantage over higher-cost active funds can be significant.
2. All Indexes Aren’t Created Equal
There are a wide range of low-cost index mutual funds and ETFs covering widely used indexes across the nine domestic Morningstar style boxes, as well as widely used foreign stock indexes. The same holds true on the fixed income side of things.
The explosion of ETF index products in recent years has led to a whole slew of index funds with underlying indexes that were essentially created in the “lab” with results that are mainly back-tested as opposed to having real market results.
3. Index Funds Don’t Necessarily Reduce the Risk of Loss
Investors in an index fund or ETF tracking the S&P 500 during 2008 lost roughly 37 percent plus the fund’s expenses reflecting the decline in the underlying index. Investors in index products tracking real estate in the form of a real estate investment trust (REIT) or emerging market stocks suffered large losses as well. Index fund investors do, however, eliminate managing risk. This is the risk of an active manager underperforming the benchmark associated with their investment style due to the investment choices they make in managing the fund.
4. Index Funds Don’t Ensure Investment Success
Just investing in an index fund or two doesn't mean that you're on your way towards achieving your investment or financial planning goals. Index funds are tools just like any other investment product. In order to gain the most benefit from using index funds either exclusively or in combination with active funds you need to have a strategy.
Conclusion
Investing in index mutual funds and ETFs can be an outstanding low-cost strategy for all or a part of your investment portfolio. Like any other investment strategy, investing in index funds requires that you understand what you are investing in. Not all index products are the same and investors need to look beyond the “index fund” label to make sure they are truly investing in a low-cost product that tracks a benchmark that fits with their investing strategy.
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