Advisors and analysts have long touted index funds as a way to follow the market in a consistent, low-cost way, but they aren’t all created equal. An index fund is a diversified group of publicly traded securities designed to mimic the performance of a market index.
“While the word ‘index’ may conjure up an image of safety and reliability, that is not always the case,” says Sarah M. Lewis, a principal of Aequitas Wealth Management in Los Angeles. That’s partly because the funds track everything from widely known indexes like the Standard & Poor’s 500 index to one custom built for the fund and without much of a track record.
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Index funds should “move in lockstep with the benchmark index they are tracking,” says Drew Miyawaki, head of global equity trading for Chicago-based Legal & General Investment Management America.
But before you jump on the broad exposure to the stock market that index funds offer, it helps to understand what they are — and what they aren’t. Experts reveal the following myths about index mutual funds and exchange traded funds.
Index funds are safe. Index funds generally tend to be less volatile than most individual stocks, says Robert R. Johnson, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania. But they are only as stable as the underlying index. It can be “plain vanilla” like the S&P 500 index or MSCI EAFE index or it can be a leveraged index ETF that amplifies the return or loss by a factor of 3, says Lewis: “The more exotic the index, the more the investor needs to put it under the microscope.”
New funds are often back-tested by their sponsors, which means the fund sponsor has re-created the past and examined how its fund would have performed with the benefit of hindsight, Lewis says. These tests aren’t always reliable. “We have gone down the rabbit hole on more than one occasion and found that the back test was long on glossy paper and short on verifiable data and assumptions,” she says.
You also want to look at the index fund’s holdings to keep your money in the right places. Lewis says to ask whether the ETF holds actual stocks or if it is a synthetic fund that tracks the underlying index with derivatives but doesn’t actually own any of the shares.
Index funds match exactly the funds they track. Fund managers make adjustments to index fund holdings that may not be an exact replica of a sector. But even if they were, index funds would underperform because of the fees associated with the fund, says Jason J. Howell, president of Fiduciary Wealth Adviser. “Portfolio managers choose a smaller mix of companies, a different proportion of company size and higher or lower levels of cash to mitigate that drag on performance,” Howell says.
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Index funds are passive. There may be more to an index fund than just following the market. “Benchmark [index fund] selection is an ‘active’ decision,” Miyawaki says. Investors should try to understand the construction and methodology of the fund’s benchmark to see if it matches their goals and objectives, he says.
Index funds perform consistently. An index fund can underperform its benchmark for many reasons, Miyawaki says, including a high expense ratio, which may include hidden fees that can make an index fund expensive. Also look at turnover, which is how often assets in the fund change. “The higher the turnover, the more costly the fund. This is especially relevant in a mutual fund index,” Lewis says. An index ETF will provide more tax advantages than index mutual funds because mutual fund managers often distribute taxable gains at the end of the year.
“The challenge for individual investors is not how to maximize performance. The challenge is how to avoid the bad decisions that drive underperformance,” says Jim Hemphill, chief investment strategist for TGS Financial Advisors in Radnor, Pennsylvania. Indexing is the most obvious way to avoid bad decisions, but only if you commit to an index as a way to avoid making any active decisions. And you do that by buying into as broad an index as possible, he says.
Index funds are good for the short term. Some index funds could experience less volatility than others, and some are designed for shorter holding periods. But don’t invest in an index fund unless you can sit it out for at least five years, Lewis says. “Ten is even better. If that criteria is met, an index fund can be an excellent vehicle for investing in the market,” she says. “Our top choices for index fund providers are Vanguard, iShares, Charles Schwab, JPMorgan, and Dimensional Fund Advisors.”
[See: 7 Bond Funds to Buy as Rates Rise.]
If you need the money soon, consider more conservative short-term bond funds, CDs, or high-yield savings accounts, says Benjamin Sullivan, a certified financial planner and an enrolled agent with Palisades Hudson Financial Group in Austin, Texas. “Stock index funds and even most bond index funds take on more risk than is appropriate for cash you’ll need in the short term.”
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5 Myths Everyone Should Know About Index Funds originally appeared on usnews.com