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The Disadvantages Of Index Funds

By Author: Brooks Richmond
Total Articles: 99

Index funds have been promoted as a simple way to use a market or a set of markets to produce financial growth. You are supposed to be freed from the disadvantage of actively managing your own portfolio by reliance on a financial adviser and financial planners with aims to play the index instead of going to the effort to pick stocks that will beat the index.

Index funds do have a place in your asset management scheme but there are several disadvantages to index funds that should prevent you from banking your entire retirement on an index fund.

Index funds really are tied to the volatility of a few stocks instead of the index. New stocks that are performing well are added to the index and stocks that did not do well are dropped from the index. This addition and loss occur usually once a year. If your asset management services are not paying attention to the individual stocks and how they are being traded then you will lose money when the new stocks are added and the low performers are dropped.

Even though the idea of an index fund is to spread your risk over a range of stocks and prevent loss, the reality is that the smaller the index is that your investment management planner has selected the more likely you are to end up losing money. In a small index fund you are really putting all your eggs into one or two baskets. Those baskets are the few stocks that are going to make large gains in a year. If your fund is structured where you cannot get in and get out quickly you stand more than a 50 percent chance of losing all the gains you made in the run up when the few great performers start to tank.

Another disadvantage of index funds is that you do not get the full advantage of the normal business cycle. Every company has its ups and downs. Once a company drops out of the index fund you are in, you do not have the chance to profit from the company’s turnaround if one occurs. Just think of the ups and downs Apple has experienced over the long term. You will have to wait as long as a year to get the benefit of a comeback performer that will not be added to the index until a specific date.

Unless you get in or get out in March when most of the index funds are reevaluated then you can end up buying high and selling low with the few stocks that actually make the index change.

The actions of an index fund manager make sense for the index fund. If a stock begins to underperform then the fund manager will drop the stock and sell the shares. This action makes the price of the stock drop further and it means that you lose more money if you are stuck in a fund that does not allow you to get out quickly.

Index funds can also be the victims of timed electronic trading also known as algorithmic trading. If a broker has inside information or just plain insight and market savvy to see that one of the stocks in your index fund is going to tank, then they will dump all of the shares they have in a trade that takes microseconds. No financial advisor or money management services can trade at this pace. The end result is you lose money because index funds just cannot trade at the pace of electronic traders.

You have to 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 happens regardless of your index funds position in the market. You can find yourself in the position of losing most of what you gained to taxes if your index drops 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 charges, and administration can be as high as 1.2 percent of your portfolio at the time the fees are accessed. You can know the fees up front and there are many index funds that have no fees.

Index fund managers may practice activities that benefit the fund instead of the investor. If a fund is taking a bath a manager may trade too often and too quickly in an effort to meet a predetermined quarterly goal. This activity is usually not to your advantage. One sign of poor management is slow trade execution.

Part of the disadvantage of index funds is the large cash reserve that the fund must maintain to cover withdrawals. This money does not make money for you.

The number of index funds and the indices the funds are tied to can be a challenging choice even to the most experienced investor. There may be tracking errors that while limited to five points can be a major hit to your portfolio.

Index funds are not all bad. You really need as much advice and information as you can possibly get to make money with index funds. InvestBetter is one of the better resources for information. The idea is to diversify. You have all heard this before and it is still just as true as the first time anyone said it.

Your best bet for a portfolio that produces a comfortable retirement is diversification, advice from a proven financial adviser, and active participation in how your money is working for you.

Financial Advisor

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