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How Risky Are Index Funds?

02/13/2019

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There are a number of investors, whether long or short, who would ask how risky are index funds. Many investors would argue there is little risk involved. This is mainly due to the little time, research, and diversification needed to start investing using a fund. All those factors seem to be of minimal consequence when opting into an index fund. In fact, even the fund fees tend to be low making it a widely available investment for finance-focused individuals and long-term investors. However, beneath all the minimal tradeoffs are some notable dangers for investors to keep an eye on.

There Are Dangers to Investing in Index Funds

There are a few dangerous points for investors to consider before taking up a significant stake in an index fund. It is especially important point to remember that during the terms of a lengthy bull market run, not all investments are necessarily safe. Even though bull markets usually mean high flying times for investors, not all sectors of the market experience growth during a bull run. The market as a whole may not be entirely safe for investment.

There are many downward spirals associated with bull markets that investors should be wary about. These spirals are what investors need to keep an eye out for in the long term when it comes to investing in stocks and bonds. Investors should be watching closely because the downward spirals during a bull run point to the larger situations of market concern. These concerns are more relevant for investors who are considering buying into an index fund due to the market volatility.

Index funds can be highly volatile financial vehicles in terms of trading activity during downward spirals in the market. For example, the 2008 financial crises – took place because the housing market went under – led to a deep dive in various sectors of the market. Morningstar research points to a high correlation of movement in an index fund before and after a market correction takes place. This point comes up when evaluating whether index funds really do diversify their securities enough. Investors should be particularly focused on diversifying their assets to better manage potential trading risks, including downward spirals in the market and other larger crises.

Hard to Recover from Market Downturns with Index Funds

The rise of many different types of index funds has given investors the opportunity to diversify their assets in more ways than just a few. Investors will always choose to diversify their assets due to the benefits that come from protecting their investments from sudden market downturns.

Index funds can have particular focuses in many different areas of business, such as in technology or retail. There are also index funds that look at specific elements of the market, including market capitalization and share price. On top of these aspects, investors can also choose funds with varying levels of risk associated with long-term holdings and securities.
In a nutshell, there are many different ways for index funds to capture elements of the market. The sheer number of options available to an investor makes it a challenge to choose. Each investment vehicle allows the investor to explore a different side of the market.

These vehicles, index funds, potentially expose an investor to a different area of the market based on how the fund is broken down. Index funds select securities, including stocks and bonds, that follow certain market factors such as being large cap or small cap stocks.

When it comes to the question concerning how risky are index funds, investors do not need to have an extensive knowledge of the market to jump in on investing in a fund. Investors can enjoy easy access to a wide variety of index fund options, which directly diversifies an investor’s securities. However, bear markets have shown investors the true extent to the risk they are taking on when they invest in index funds. Index funds are structured in ways where the fund is exposed to particular areas of the larger market. That is why index funds can capture large positive and negative performances in the market space.

The downside to experiencing a market swing with an index fund is that if the market is in freefall then it is hard to recover losses. You will likely experience the full impact of a market downturn by investing in an index fund during a bear market. An index fund is likely going to follow the market accordingly, since the securities that make up the fund were selected to track the market in a particular way.

Fixed Structure to Index Funds

Broad market index funds cannot capture specific upturns or downturns in the market. This is because the fund – by its makeup of securities – is following the changes in the larger market. Specific sectors are not being tracked using this fund. This makes it complicated to recover from losses in a market downturn using a broad market index fund. Fund managers are limited in the financial moves, essentially the trades, that they can make to keep the index fund at a point where it can track the market and recover losses from poor performing securities. The limited moves available to a fund manager handling a broad market index fund is what investors see as a fixed asset, or at least a limiting one.

The Drawback of Index Funds in A Bear Market

Additionally, fund managers facing off with a bear market situation can be provoked to make poor investment decisions. Poor conditions in a market, which affect index funds, could lead to more trading. And additional trading puts higher costs on all stakeholders. Those costs, which includes taxes, are shared among the investors in the index fund.

Research has shown that an active investment fund has the potential to outperform an index fund during market downturns. And fund managers can do a better job of buying low and selling high in an active fund than in an index fund. If an active fund manager can curb losses during a bear market better than an index fund manager, then investors are more likely to stick to an active fund in the long run. Investor confidence in a fund is important because it gives the fund manager more room to make financial decisions.

A fund manager that worries about investor confidence is pressured to make decisions that produce returns quickly. Coming up with quick returns is not always a realistic scenario, especially under pressure. When investor confidence is high and stakeholders are likely to hold onto the fund in the long-run then a fund manager does not need to sell securities for less than they were bought to meet redemptions.

Index funds may be preferable for investors these days, since research by various multinational banks point to index funds performing better than active funds over the last decade.

What Do Investors Need to Remember Before Investing?

While index funds are relatively secure investments, new investors should remember that these funds tend to follow the market in particular ways. Understanding what portion of the market is being tracked and how well that part of the market is doing are key considerations. Without a full understanding, you could misread market clues and end up with a costlier fund than you had expected. The costs incurred would likely come from higher trading and taxes on each of the trades. Additionally, losses can occur if a fund manager is under pressure to turn the tide on a poor performing index. And an index fund can perform poorly for a number of reasons as well.

It is important to know whether the index fund has a safe and diverse range of securities before deciding to invest. Part of answering the question on how risky are index funds involves knowing whether the securities in the fund are stable. A varied index fund helps a lot under circumstances of the market taking a turn for the worse, since there are other sectors to balance out the fund’s losses.

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