The Pros and Cons of Investing in Index Funds

It’s no secret that index funds are all the rage nowadays. The first index fund was created by John Bogle and made its debut on December 31, 1975, and since then, this class of investment funds has grown steadily in popularity, especially among first-time investors. 

For the uninitiated, an index fund is an investment that mimics a market index, such as the S&P/TSX Capped Composite Index. The index fund’s manager will purchase all the securities that make up the index according to their weighting to replicate it as closely as possible. 

Suppose you’ve recently thought about putting your money to work in index funds. In that case, it’s crucial to familiarize yourself with both their pros and cons to determine if they should indeed have a place in your investment portfolio.

The Pros of Index Investing.

Broad diversification. Anyone who’s dabbled in the financial market knows diversification is one of the key pillars of successful investing. It’s never wise to put all your money in one stock, as there’s always the risk of that stock’s value plummeting to zero. Even concentrating your holdings in one industry is unwise, as bear markets can negatively impact one sector more than another. The unique risk attributed to one specific company or industry is called unsystematic risk.

By investing in index funds, you gain exposure to hundreds of different securities at the same time. Should one stock collapse, there’s another that will soar to offset the loss. A portfolio composed of index funds will provide you with access to almost every industry and sector of the economy, greatly whittling down your unsystematic risk. 

Low Fees. Excessive fees can erode a good chunk of your returns. Even a 1% fee can undermine your investment goals, so you should seek to minimize them as much as possible. The low costs that accompany index funds make them attractive candidates for investment portfolios. 

Since index fund strategies are relatively straightforward to implement and monitor, investment firms can set low fees, known collectively as the management expense ratio (MER). For example, the iShares Core S&P/TSX Capped Composite Index ETF (ticker symbol XIC) has an MER of 0.07%. That’s just $7 for every $10,000 invested. Even better, new funds are cropping up that have no MER, like the Fidelity ZERO Large Cap Index mutual fund.

Passive investing. If you prefer a hands-off approach to wealth building, index investing could become your preferred investment strategy. The most challenging aspect of index investing is choosing which group of index funds you want to invest in – after that, everything runs on autopilot. You can employ dollar-cost averaging and purchase shares of the same fund(s) every month (a robo-advisor makes this easy and convenient). No need to analyze endless stock charts or obsess for hours about financial news tweets – just set it and forget it.

Exceptional returns.Index funds have performed extraordinarily well when compared to their actively managed rivals. For example, a research study by Morningstar showed that only 23% of all actively-managed funds exceeded the average return of index funds over ten years ending in June 2019. Similarly, a 2018 report conducted by S&P Dow Jones Indices revealed that over a 15-year time frame, 76.49% of large-cap active equity funds trailed their respective benchmarks. 

If you opt for index funds, you have the potential to earn consistent returns that mirror the market average for many years. For example, the average annual return on the S&P/ TSX Capped Composite Index during the last ten years ending on May 31, 2021, was 6.81%. During the same period, XIC (an ETF that tracks the index) achieved a remarkably similar return of 6.73%. 

The Cons of Index Investing

No opportunity to outperform the market. With index funds, there’s no chance you’ll earn returns that exceed the market. In fact, you’ll lag by a small amount due to tracking error, which can adversely impact your total return. If you possess a healthy appetite for risk-taking and are looking for superior returns, you’ll probably find actively managed funds with solid track records more appealing.

Suppose you’ve failed to hit your investment targets over the years and require above-average returns over a short period to make up the shortfall. In that case, index funds will likely yield disappointing results, as their attractive returns are typically realized long term. You may not have that long, so it may be more prudent to seek alternative investments to reach your goals.

No downside protection. It’s usually smooth sailing for index funds in a bull market. But when the economy crashes and a prolonged bear market ensues, index funds don’t fare that well. 

Market downturns severely affect index funds, possibly erasing a decade of gains in only a single year. For example, during 2008, The S&P 500 dropped by 38.49%, and any index funds tracking it posted similar losses. It took a considerable amount of time for many investors to recoup those losses. Some never recovered, especially if they were near retirement at the time.

With index funds, you’re at the mercy of the financial markets – they don’t come with an insurance policy to protect you when disaster strikes.

No ability to diversify into other investment strategies. There’s a wide array of investment strategies, sectors, industries, and asset classes to consider when constructing your portfolio – and each one has its time to shine.

Value stocks may outperform growth stocks over five years and then fall out of favour for a while. Commodities may post lacklustre gains for a decade, only to triumphantly come roaring back with double-digit returns. Emerging asset classes like cryptocurrencies may provide once-in-a-lifetime investment opportunities.

By committing to a few stock index funds, you miss out on other advantageous investing opportunities, which could significantly enhance your returns if you employ the right tactics. Just because the stock market has gone up over time doesn’t mean it can’t stall for a decade. It’s during these times that that exploring other investments or approaches could be worthwhile.

Final Thoughts

Like all investments, index funds have their merits and shortcomings. Depending on who you ask, they elicit either heaps of praise or scorn – you’ll have to decide where you stand personally.

Before investing in index funds, assess whether their simplicity, affordability, and low maintenance will benefit you enough that you can overlook the limited returns and rigid investment philosophy. And ensure they align with your overall investment objectives and risk tolerance.