The Downsides to Investing in Index Funds

By Markets

The biggest advantage of an index fund over other types of mutual funds is its low costs, but some index funds, like exchange-traded funds, carry other expenses like trading costs, that mutual funds do not have. In addition, due to their broad diversification, index funds can't beat the market's rate of return.

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In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss some of the downsides of index funds and why you should pay particularly close attention to the finer details of an index fund before investing.

A full transcript follows the video.

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This podcast was recorded on Sept. 14, 2016.

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Gaby Lapera: Diversification, moving on to our next topic, can be a disadvantage. For example, say that you boughtApplein 1990 when it was still really cheap. Right now,you would have a lot of money. Butif you invested in an index fundthat Apple was a component ofin 1996,you would still have more money than when you started,but you wouldn't have as great of a returnas you would have with solely having just invested in the index fund than you would have if you had just invested in Apple.

Jordan Wathen:Right. Andsome people call that "di-worse-ification," which is a play ondiversification. But if you think about the legendary investors of the world, like Warren Buffett, he wouldn't be anybody today if you made him go buy 1,000 stocks. No one would even know his name, if he had to, in a given time, own 1,000 stocks. Not that his returns would have necessarily been good or bad, butWarren Buffett made a fortune because he was superconcentrated into his best ideas. If you buy an index fund, by definition,you are rarely, if ever, super invested in one or two or three or 10 companies.

Lapera:Right. So whilediversification insulates you from acompany going completely broke,because there's so many other companies that are doing fine in the index,but it also insulates you from making mega profits that you couldif you picked one stock, in particular. For reference, I think Warren Buffett has around 50ish stocks in his portfolio right now, which is not a lot,especially considering that he has an entire investing teamfiguring out what to buy. He could have a lot of stocks.

Wathen:Right,especially considering his big four makeup. I don't know the percentage offhand, but it's a verysignificant percentage of that amount.

Lapera:Yeah. Theother thing we talked about earlier is fees. This is somethingthat you have to take into account when you're buying an index fund. The other thing you need to keep in mind when you're buying index funds, at least as an ETF, is that you are probably going to have to pay a commission.

Wathen:Right. And really, this goes for any fund, whether it's anexchange traded fund, or even a mutual fund, a mutual index fund, is that you will probably have to pay a commission. Some companies offer commission-free trades. Some brokerage houses do. But in general, those tend to be the higher expense ratio funds, so be careful with that, as a general rule. Especially with exchange-traded funds, because ETFs are bought and sold like stocks on the stock market. You have to pay a commission,just like you would if you bought and sold shares of Apple.

Lapera:Yeah. Andthe final disadvantage related to diversificationis that you are never going to outperform the market. Bydefinition, you can only do as well as the market does. Lucky for you,the market, historically, has always risenover time, even if there are some giant dipsin the intermediate,in the short term. But you're nevergoing to get a huge winner of a stock by investing in an index fund, which means you'll never have thesatisfaction of rubbing it in your boss' face when your stock picks outperform his. Heh.

Wathen:Andthat's not such a bad thing. Wedon't want to scare people away from this. Theaverageactive stock picker isn't going tobeat the market anyway after costs.

Lapera:That is super true.

Wathen:So take that into consideration.

Lapera:Yeah. In fact, the averageactively managed mutual fund is also not able to beat an index fund.

Wathen:Right,exactly.If Harvard MBAs can't do it,then you can't be too upset about it.

Lapera:I think it's something like, only 20% of mutual funds outperform their benchmarks. Something absurd, like 80%, do not. Keep that in mind.

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.