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5 Reasons To Avoid Index Funds

It seems like these days, when it comes to investing, all you hear about are index funds. People talk about how easy they are to invest in, how safe they are and of course the great returns you will receive if you place your money into them. Many people hearing this advice would probably assume that this is the perfect financial instrument however, more savvy investors know better. No financial instrument is perfect which is why I want to share with you 5 reasons someone would want to avoid investing in index funds!

For those who aren’t aware, an index fund is an Exchange traded Fund (ETF), having a portfolio designed to match or track the components of a financial market index. This is typically the Standard & Poor’s 500 index, more commonly referred to as the S&P 500. Generally, an index fund provides low operating expenses, broad market exposure, and low portfolio turnover. Regardless of the state of the market, it allows for their benchmark index. Warren Buffet, who is a renowned investor has spoken of how index funds are a haven for saving for the sake of a person’s older years.

As I previously mentioned, thanks to modern portfolio theory, index funds seem to be all the rage these days. The modern portfolio theory holds that markets are efficient, and that a security’s price includes all available information. For this reason, some advocates are of the opinion that active management of a portfolio is useless, and it would be better if investors buy an index and go along for the ride. However, stock prices, in many cases can be very irrational, and there is also enough evidence that goes against efficient markets. So, although many people say that index investing is the way to go, I’d like us to take a look at some reasons why it may not always be the best choice.

Reason #1: Vulnerability In Economic Downturns

The stock market as we all know, has done a lot to prove that it’s a worthy investment in the long term. However, it has had its fair share of economic troughs. 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 it can also leave you vulnerable to the downside.

You have the option of hedging your exposure to the index by shorting the index, or purchasing a put against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing.

Reason #2: Inaccurate Reactions

It’s not uncommon to see mispricing occurring in the market. If there’s one company that has a unique position against all other companies in its sector, but all other companies move in the same upward direction due to that one special stock, then they may become over-valued as a group.

The reverse can also be the case. A company may experience poor results that are unique to that company, but it may take down the stock prices of all companies in its sector. The sector could 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 may take advantage of this misguided behavior in the market. An investor can keep an eye out for good companies that become undervalued, based on conditions besides fundamentals, and sell companies that become over-valued for the same reason.

Index investing does not give room for such advantageous behavior. When a stock becomes over-valued, it begins to carry more weight in the index. Sadly, this is just when astute investors would want to lower their portfolio’s exposure to that stock. This means that even if you have an idea of a stock that is over- or under-valued, and you invest solely through an index, you will not be able to act on that knowledge.

Reason #3: No Control Over Holdings

As we know, indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You could have a specific company (or companies) that you like and plan to own, it could be a bank or a food company that you have researched and want to buy.

In the same vein, in everyday life, you could have certain experiences that lead you to believe that one company is markedly better than another. It could be that they have better brands or customer service. Hence, you may want to invest in that company specifically, and not in its peers. At the same time, you could have ill feelings towards other companies for moral or personal reasons. For instance, you may have issues with the way a company treats the environment or the products that they manufacture. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands.

Reason #4: Limited Investing Strategies

There are so many strategies that investors have used successfully. Unfortunately, purchasing an index of the market may not give you access to a lot of these good ideas and strategies. Investing strategies may sometimes be paired to give investors better risk-adjusted returns. Index investing will give you diversification, but it may also be achieved with as little as 30 stocks, instead of the 500 stocks that the S&P 500 index would track.

If you do some research, you could find the best value stocks, the best growth stocks, and the best stocks for other strategies. After your investigations and your findings, you can combine them to a smaller, more targeted portfolio. By doing this, you could provide yourself with a better-positioned portfolio than the overall market, or one that is better suited to your personal targets and risk tolerances.

Reason #5: Investing Stress

Lastly, investing can be worrying and stressful, especially during times of market turmoil. Picking certain stocks could leave you checking quotes on a constant basis. This can also give you sleepless nights, but these situations will not be averted by investing in an index. You may still find yourself constantly looking up on how the market is doing and being very worried about the economic landscape. To add to this, you may lose the satisfaction and excitement of making good investments and being successful with your money.

Now, the truth is that there are studies that lean both in favor of and against active management. A lot of 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, that is if you want to look at the wider economic view, but there are lots of reasons why it is not always the best route to achieving your personal investing goals.

In fact, the rich generally avoid this investing strategy. Earlier, I mentioned Warren Buffet, the world-famous investor, and how he speaks of the benefits of investing in low-cost index funds. However, despite Buffet’s advice, wealthy individuals typically do not invest in simple, low fee, market-matching index funds. Rather, they invest in individual businesses, art, real estate, hedge funds, and other ventures with high entrance costs. Such risky investments usually demand huge buy-in costs, and they carry high fees while promising the opportunity for outsized rewards.

Let me share with you an example of how the rich invest. Let’s take Steve Ballmer, the Ex-CEO of Microsoft, whose net worth is roughly $52 Billion. Despite parting ways with Microsoft, he owns hundreds of millions of shares in the company. His share is about 4% of the company. However, Ballmer also investing in a multitude of other companies and industries. For instance, he owned a 4% stake in Twitter up until 2018 and owns numerous real estate investments. Not to mention, he owns the LA Clippers NBA team.

His wealth is concentrated on a handful of investments, which is a far cry from the hundreds of investments that come with Buffett’s suggestion of buying low fee index funds. Hedge Funds are also popular among wealthy investors. These funds require investors to demonstrate $1,000,000 or more in net worth and use sophisticated strategies intended to beat the market.

However, hedge funds charge about 2% management fees and are subject to 20% capital gains. Therefore, investors need to get huge returns to support such high fees. This doesn’t imply that wealthy investors do not own traditional stocks, bonds, and fund investments, because they do. Still, their wealth and interests open doors to other types of exciting and exclusive investments that aren’t typically available to the average person. Now, as I just mentioned, the rich invest in non-traditional financial vehicles but they also invest in common assets. However, index funds are still not a top choice for these investors for a few reasons.

Over the past 90 years, the S&P 500 averaged a 9.53% annualized return. You would assume the wealthy would be satisfied with such returns on their investments, right?. Some may, however, rich folks take risks in the service of multiplying their millions (or billions). For example, George Soros, who is also a world-famous investor, once made $1.5 Billion in a single month by betting that the British Pound and other European currencies were over-valued against the German Deutsche Mark.

Hedge funds target such gains, though history has more than enough examples of years when hedge funds failed to outperform the stock market indices but can also yield for their wealthy clients. This is why rich individuals are more than ready to risk huge buy-in fees of $100,000 to $25 million for a chance at reaping great returns. The one percent’s investing habits also tend to reflect their interests as many rich people earned their millions through their business.

They look at this part as a means to keep on growing their finances while sticking to what they know best — corporate structure and market performance.

Wealthy people also fancy classic cars, art, homes, and collectibles. By buying those luxuries, the rich enhance their lifestyles, and they enjoy the value appreciation of those luxuries as a decent bonus for their net worth. Wealthy people have huge incomes, net worth’s and opportunities. Although they look for unique investments with the hopes of seeing worthy returns, not all their ventures pay off with profits greater than a low fee index fund. Nonetheless, since they have more than enough money at hand to survive, they are less dependent on steady returns.

An unsophisticated investment strategy in low fee index funds is good enough for an investor like Warren Buffett, and may not even be the right strategy for you depending on the returns you aim to achieve and the rest of your financial goals.

Riding the market rollercoaster is a big part of investing in index funds, and not every investor can stomach that. If an investor cannot invest without feeling the occasional bumps, and that action makes you sick, you may want to quit on this investing strategy.

In fact, if you find that you are generally a nervous investor who is susceptible to succumbing to these emotions and selling when the market is down, a manager may calm your fears. One of the most popular investments today is the target-date or life-cycle fund, which are designed to suit investors of a similar age, and which grow more conservative as shareholders reach retirement.

While there are choices based on a mix of index funds, using these funds is really about getting the suitable allocation and glide path for your investments. You will gain the benefit of having your portfolio actively managed by a professional while you can sit idly by and pre-occupy your mind with other things.

In short, while there are benefits to investing in index funds, they aren’t the perfect investment that many people make them out to be and by understanding this, you can put yourself in a better position to succeed in your investing efforts!

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