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Index Fund Risk: What You Must Know Before Investing

02/15/2019

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Index fund risk is rarely discussed, likely because it is often overlooked and frequently misunderstood.
This is a troublesome fact at a time in which indexing has taken over 30% of total ETF and mutual fund assets, a figure expected to rise above 50% in 5 years.
Many investors assume that index funds are safe vehicles, which is only partially correct. If that’s the case, what kinds of index fund risks should you be wary of then?

Understanding Volatility and Diversification

Passive investing has been supported by the belief that global capital markets are mostly efficient, and that any inefficiencies are impossible (or cost prohibitive) to serially identify for professionals and amateurs alike.

Instead, many academics and financial professionals advocate for broad exposure across asset classes, relying on the almost magical growth forces embedded in capitalism to spur appreciation for investors.

Who Are Index Funds For?

Index funds are not designed for stock pickers or market timers, but they are great tools for buy-and-hold investors with long-term planning in mind. People can mitigate company-specific index fund risks by diversifying, thus insulating themselves from the full chaos caused by overexposure to the Blackberrys or Enrons of the world.

Instead, the risk is more accurately understood as volatility, which is a short term phenomenon. Over long time frames, global capital markets are efficient tools that tend toward a mean, and they will continue to grow unless there is a total and long-term failure in the global economy.

However, capital markets can be inefficient in the short term, resulting in the market cycle with which we have become accustomed to.

The market is certain to go down at some point, and passive investors embracing the benefits of upside volatility must also be prepared for the inevitable fall. With proper diversification, an index fund risk is no longer the threat of lost investment. Instead, someone will be forced to source capital from an account that’s temporarily below value.

When Volatility Creates Losers

Pullbacks happen at some point almost every year, and bear markets occur once every five years on average. The S&P 500 has never had negative returns over a 15 year period, but it very rarely fails to recover within a 5 year window, even following difficult downturns.

Index investors should use this knowledge to their advantage when crafting portfolio allocations. Capital that is assumed to be allocated for use outside of securities markets (think college tuition, retirement, home down payments, seed capital for a private business) within five years should have limited exposure to volatility if investors want to mitigate the true index fund risk presented by a diversified portfolio.

Time horizons in the 5-10 year range should balance growth opportunity with low-volatility instruments. Remember, if the market declines, and we expect it to recover in the long term, your losses are unrealized as long as you refrain from selling.

Correlation and a False Sense of Security

Index funds now account for 30% of all mutual fund and ETF assets, and this influx has caused apparent valuation distortions for individual securities that fall on either side of the popular benchmark indices. This would suggest that index funds must overpay for certain securities at the expense of shareholders. However, it also demonstrates a worrying trend that funds are developing disproportionate pricing power that overwhelms supply and demand based on fundamentals of underlying companies.

This could hamper the independence of securities, causing more correlation among constituents and undermining the benefits provided by diversification. These effects are especially apparent in small- and mid-cap stocks.

It is either very difficult or impossible to consistently and accurately time markets, even for the most talented investment teams. That said, active management strategies appear to deliver superior performance on average in bear markets and in periods of high volatility.

As indexing continues to gather more influence in capital markets, it is likely to exacerbate the severity of downturns and bear markets. This should create more opportunities for outperformance among active managers at the expense of index fund shareholders.

Your Expectations Are Not the Reality

Tracking error is not an obvious index fund risk for professionals who are well-acquainted with the associated impacts, but more novice investors might have disastrous outcomes if they fail to account for this.

A Gap Between Portfolio and Real Results

Most of the popular index funds do an excellent job allocating in ways that closely mimic the returns of their target benchmarks. However, there is still some gap between a fund’s real results and those of the hypothetical portfolio it aspires to be. This can be due to predictable expenses and some less obvious forces at work.

Taxes, management fees, trading costs and transaction fees all erode returns relative to an index, causing investor results to fall short of expectations. Taxes and transaction expenses incurred at the individual level further dilute returns.

There are also active management strategies that revolve around buying and selling securities expected to enter or exit indices in periods of rebalancing or reconstitution. These can distort the costs of important securities at precisely the times index funds are selling or purchasing them – and the results are almost never in favor of the fund’s holders.

In any case, index fund investors must understand that the growth they will enjoy over the long term will almost certainly fall short of the headline numbers popularly cited for the indices themselves.

Fully Exposed to Self-Sabotage

Over the past 75 years, there has been a 5% or greater decline every six months, on average. These are followed by rapid recoveries, but some lead to lethargic markets. Others signal the start of crippling bear markets.

Retail investors have no reliable resources to differentiate between blips and bears, and their performance has often suffered as a result of irrational behavior related to market fluctuations. The average retail investor return remains far below that of the market, even though index funds, robo advisors, and educated DIY investors proliferate.

Index fund investors must understand the full power and drawbacks of volatility, and they must resist the instincts that consistently cause people to buy high and sell low.

Mitigating Index Fund Risks

Indexing may not always be a viable strategy, because it starts losing efficacy if the entire market is comprised of indexers.

Pricing efficiencies must be driven by a marketplace of active investors’ buying and selling based on the the information available to them.

Indices have no market to track if they are the only actors in a market.

The realization of this theoretical issue is not imminent, but the marketplace could change rapidly as that breakpoint approaches, creating some turbulence for index funds.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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