Problems With Index Funds

If you invest in a Standard & Poor’s 500 index fund that is supposed to track “the market”, you are buying a fund that invests in all 500 stocks, with the same weighting as each stock has in the index.  This fund is managed by the Index Fund Manager, who is charged with buying and selling stocks as new money comes into the fund, as money leaves the fund, and when the specific common stocks in the S&P 500 change. Note that index funds are considered to be “passively invested”, as opposed to “actively invested” mutual funds where the fund manager has choices about which stocks to buy and sell, and how many dollars to invest in each stock.

The idea of an index fund is that you receive most of the return of the S&P 500 market index (which represents about 75% of the total dollars invested in the U.S. market).  This avoids the probability that your account will perform significantly worse than common stocks generally (or at least 75% of what is commonly referred to as “the market”).

But are you really receiving returns that are virtually identical to the S&P 500?  The answer is “no”, for a variety of reasons:

First, the fund charges a management fee.  For example, the Vanguard 500 Index Fund charges a management fee of 0.18%/year, probably the lowest management fee of any similar fund offering.  Vanguard claims that the average fee for similar funds is 1.02%!  So even if the manager’s investments are identical to those of the S&P 500 prior to the fee, your investment returns are somewhere between 0.18% and 1.02% (or more) behind.  So in the attempt to avoid a situation where your investments perform significantly worse than “the market”, you have virtually guaranteed that your investment performance will be worse than the market.  Under performance that accumulates over many years can eat into your nest egg by 30-40% or more.

Second, there are investors buying and selling the mutual fund all the time.  When these other investors buy and sell, it forces the fund manager to incur transaction fees (and possibly generate capital gains on which you will be taxed).

Third, an index fund has what is known as “low turnover”.  This means that if you buy in to the fund many years after it was initially offered, there may be a significant gain that is already built into the fund the day that you buy it.  If other investors in the fund suddenly sell, you may find yourself paying a tax on an investment that you yourself did not earn gains on. 

How does this work?  Let’s say that when the fund was new, it sold for $10/unit.  Over time, the fund’s investments rose in value to $15/unit, and none of the shares had ever been sold.  You buy into the fund at $15/unit, and your units represent 1% of the fund.  That same day, one fund holder sells his units, and this represents 10% of the fund’s value.  The fund manager has to sell 9% of the investments in the fund to pay that investor off.  So the fund generates a capital gain on the common stocks that they sold of 45 cents/unit ($5 gain multiplied by 9%).  Your $15/unit value now has generated a 45 cent/unit capital gain, which at a 20% capital gains tax rate generate a 9 cent/unit tax to you.  If you held 1000 units, your tax would be $90, yet your original purchase price was $15, and it is still $15.  You are now liable for a tax on a capital gain that you yourself did not benefit from!  This is a weakness in all funds, but in particular, index funds and “tax managed” funds that minimize the capital gains that they generate (and in so doing, leaves a larger unrealized gain for future unitholders to pay).

Fourth, an index fund has what is known as “tracking error”.  This can occur when a common stock is added to or subtracted from the stock index that the fund is tracking.  For example, when Exxon bought Mobil, the S&P 500 no longer had 500 names in it, since both were in the S&P 500, and after the merger, one of them vanished.  So the management group that decides which stocks to own in the S&P 500 index had to add another stock to get back to the 500.  Although the fund does its best to buy and sell as stocks are added to or subtracted from the index, the fact is that the fund manager is being reactive, rather than proactive.

Some fund managers may cheat a little and only invest in the top 300 of the 500 stocks.  They can do this because the top 300 may be, say, 95% of the total value of the S&P 500, with the other 200 (the smaller companies) representing the other 5%.  This will also introduce tracking error into the mutual fund’s returns.

Other mutual funds invest in stock index futures rather than the actual stocks themselves.  This is a complex strategy that is beyond the scope of this article to explain.  But this is another way in which tracking error can be introduced into a mutual fund’s investment returns.

Often, just the public notice that a stock will be added to the S&P 500 will cause that stock’s price to spike in value, as other investors rush in to purchase the stock ahead of the Index Fund Manager.

Some Index Fund Mangers try to guess which stocks will be added to or subtracted from the S&P 500 Index and “front run” – that is to say, trade before the management group that decides which stocks will be included in the S&P 500 Index announces their decisions.  This, alone, can have a positive or negative effect on how the S&P 500 Index Fund tracks the S&P 500 Index.

A final issue is this:  is tracking the market really in keeping with your investment objectives.  If you are looking for more stability (in other words, less risk than the market), or if you are looking for income rather than growth, investing in an actively managed fund with investment objectives that are closer to yours may be a better option.

For investors who know little or nothing about investing, and do not feel comfortable in hiring an investment advisor, investing in an index fund may make sense.  Some investors who are just starting out and have small sums to invest may not find an investment advisor willing to advise them.  Others, such as Labrador Investments, LLC, are willing to work with newcomers with small amounts of cash to invest.

But for whatever reason you choose to invest in an index fund, be aware that the returns that you receive probably will not be equal to the Index’s returns, and more often than not, your returns will be somewhat less.