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What You Don't Know

3 Costly Misconceptions About Index Funds


Passive investing has grown in popularity over recent years as investors look for good performance with low fees. In fact, passive index funds now hold 42% of all U.S. market assets and that number is only expected to grow as many retail investors look to adopt this popular style of investing.
However, as most people’s moms once said, “If everyone jumped off a cliff, would you?” Popularity and herd mentality do not always mean that something is a great idea. There are a lot of attractive reasons to consider index funds which are very well known by investors but some of the downsides of choosing index investing are not as well known.
This article will take a closer look at some of the most common misconceptions about index funds that could actually be costing investors money as they work toward their goals including retirement, buying a first home, or paying for a child’s education.

Misconceptions About Index Funds

To be clear, this piece is not meant to be a takedown of index funds. For many investors, these funds may be a valuable part of an investment portfolio. However, there are some common misconceptions about these funds that should be known.

With this knowledge in mind, investors will be able to make more educated decisions about their investments and feel confident in the choices they have made.

1. Index Funds Cost Less

One of the most common reasons that investors are drawn to index funds is their low cost. There is no disputing this fact. Many index funds boast incredibly low management expense ratios (MER). Some funds even offer an MER near 0%.

It’s no wonder why cost-conscious investors who would like to make the most out of their money want to invest in index funds with low costs. However, a low MER only tells one part of the story. Many other costs could be hidden behind that enticingly low MER.

However, there could be additional fees passed on to investors over and above the MER. These fees could include trading fees, taxes, and the opportunity cost of tracking errors where the index fund underperforms the index it was designed to track. All of this can add up to make those low-cost index funds quite expensive when all is said and done.

2. Index Funds are More Tax Efficient

Many people are concerned about taxes when they invest. Tax advantaged accounts like an IRA or 401k, for example, shield investors from the taxes they may be responsible for due to gains.

However, non-tax advantaged accounts do not offer this benefit and, as a result, many investors look to index funds to reduce their tax obligation when it comes time to file. However, it’s important to know that not all passive investment strategies are tax efficient.

When investors hear “passive” they assume that there likely won’t be a lot of activity and, therefore, little to no tax considerations as a result of selling assets. The truth is that fund managers must continually ensure the balance of assets in the fund meets the stated goals of the fund. This could mean that assets have to be sold in order to buy other assets. If a gain was realized due to the sale, that tax must be passed on to investors in the fund. This tax burden can come as a shock for investors who were under the impression that all index funds were passive and tax efficient.

Poor tax efficiency can become even more pronounced with major market swings as large numbers of investors put money into the fund in a hot market or pull their money out in a down market.

Fund managers may have to sell assets to pay out investors or buy new assets with new funds. Both scenarios could incur taxes and trading fees that must be passed along.

3. Index Funds are More Stable Investments

Index funds, as the name suggests, are designed to track specific indexes or industries. This is done by holding a bucket of assets that reflect the makeup of that entire index or industry. People incorrectly believe that this means index funds are more stable and less prone to massive downswings in the market.

Part of the reason for this misconception is that the markets have recently seen the longest bull run in history. For many investors, the last 5 to 10 years have provided a steady increase in portfolio value and index funds, if structured properly, have followed the steady rise of the market.

It’s important to remember that index funds have many of the same downside risks as other funds and investing styles. In fact, since index funds don’t pick winners and losers in the market, the downside risk could be amplified in a market downturn. The bucket of assets held by an index fund would theoretically include strong companies as well as very weak companies which may even cease to be listed on the markets were they to go bankrupt if the economy were to enter a recession.

In addition, since index funds can be designed to track any industry or index, there may be some funds designed for growth that track very volatile industries prone to large swings in value as the market moves. For example, technology stocks have been shown to be volatile recently. An index fund that tracks this industry may be far less stable than an actively managed portfolio that better reflects the risk appetite of the investor.

Finding the Right Investment is Key

As mentioned, this is not meant to be a takedown of index funds. These funds can be a very valuable part of a portfolio. However, it is important to recognize the true costs of index funds, see that they are not all built the same, and find the right investment for your own needs.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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3 Costly Misconceptions About Index Funds

Passive investing has grown in popularity over recent years as investors look for good performance with low fees. In fact, passive index funds now hold 42% of all U.S. market assets and that number is only expected to grow as many retail investors look to adopt this popular style of investing. However, as most people’s […]

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