5 Reasons to Avoid Index Funds

5 Reasons to Avoid Index Funds

by Wayne Pinsent

Modern portfolio theory suggests that markets are efficient, and that a security's price includes all available information. The suggestion is that active management of a portfolio is useless, and investors would be better off buying an index and letting it ride. However, stock prices do not always seem rational, and there is alsoample evidence going against efficient markets.So, although many people say thatindex investing is the way to go, we'll look at some reasons why it isn't always the best choice.
1.Lack of Downside Protection

The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. 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,but because thesemove in the exact opposite direction of each other, using them togethercould defeat the purpose of investing (it's a breakeven strategy).

2.Lack of Reactive Ability

Sometimes obvious mispricing can occur in the market. If there's one company in the internet sector that has a unique benefit and all other internet company stock prices move up in sympathy, they may become overvaluedas a group. The opposite can also happen. One company may have disastrous results that areunique to that company, but it may take down the stock prices of all companies in its sector. That 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 behaviour in the market. An investor can watch out for good companies that become undervalued based on factors other than fundamentals, and sell companies that become overvalued for the same reason.

Index investing does not allow for this advantageous behaviour. If a stock becomes overvalued, it actually starts to carry more weight in the index.Unfortunately, this is justwhen astute investors would want to be lowering their portfolios' exposure to that stock. So even if you have a clear idea of a stock that is over- or undervalued, if you invest solely through an index, you will not be able to act on that knowledge.

3. No Control Over Holdings

Indexes are set portfolios. If an investor buys an index fund,he or she hasno control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favourite bank or food company that you have researched and want to buy. Similarly, in everyday life, you may have experiences thatlead you believe that onecompany is markedly better than another; maybe it has better brands, management or customer service. As a result, you may want to invest in that company specifically and not in its peers.

At the same time, you may have ill feelings toward other companies for moral or other personal reasons. For example, you may have issues with the way a company treats the environment or the products it makes. Your portfolio can be augmented by adding specific stocks you like, but the components ofan index portion are out of your hands.

4.Limited Exposure to Different Strategies

There are countless strategies that investors have used with success; unfortunately,buying an index of the market may not give you access to a lot of thesegood ideas and strategies. Investing strategies can, at times, be combined to provide investors with better risk-adjusted returns. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500stocks anS&P 500 Indexwould track.

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, or one that's better suited to your personal goals and risk tolerances.

5. Dampened Personal Satisfaction

Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape. On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money.

Conclusion

There have been studies both in favour and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it's not always the best route to achievingyour personal investing goals.

Published and available at Investopedia.com