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9 Myths About Index Funds Set Straight

19 January 2021 No Comment

As more people get into trading, the interest around index funds and other forms of ‘passive’ investing is growing in popularity. Index funds have been presented by many as one of the best ways to get consistent returns with less volatility, reduced involvement, and lower costs.

While they can be all of that and more, not all index funds are equal, and while some are made to track serious indexes like the S&P 500, you have many funds that follow custom indexes that may not have been proven. This is one of the reasons why you must know what index funds are and aren’t before you get started. Let’s take a look at some of the most common myths floating around about index funds.

Index Funds are Always Safe

Yes, index funds indeed tend to be less volatile in general, but, in reality, it all has to do with the underlying index it’s tracking. These include well established and stable ones like the S&P 500 or the MSCI EAFE, but then you have leveraged ETF indexes where losses and gains are multiplied by 3. So, don’t make the mistake that all index funds have to follow serious indexes. The more exotic the fund, the more you’ll need to do your research on it.

Not only that but many of the ETF backed funds in the market are back-tested by those who made them. They go back in time to test the performance of their funds with the benefit of hindsight, which is in no way a reliable indicator of future performance. While back-testing can be valid, investors need to be careful with funds that consist of a lot of back-tested historical data.

Index funds also don’t automatically translate to a lower risk of losses. In 2008, investors who had their money in an index fund or an ETF tracking the S&P lost 37% in addition to the fund’s expenses, as a reflection of the corresponding index falling. Those investing in indexes following emerging stocks and REITs also suffered major losses during that period.

Underlying Indexes Always Stay the Same

This is another myth. Underlying indexes on a fund can change, and it’s often done for strategic reasons. For instance, Vanguard changed the underlying indexes for their Vanguard Mid Cap and Small Cap Index funds. This was because of changes in fees from the underlying index providers. This pushed Vanguard to change some of these so they could maintain their position as a budget index fund shop.

While there were no signs of this having a negative impact, it’s always important for investors to stay abreast of these changes. We can also expect those to become increasingly common as mutual fund providers and ETFs try to outcompete each other on price.

Index Funds are all that You Need

Some people seem to think that investing in an index fund or two is all it takes for them to reach their investment goals. In reality, these are just like any other financial instrument. If you want to get significant returns using them exclusively or in combination with other active funds, you have to make sure that you come in with a strategy.

If you want to get the most out of index funds, they are best used as part of an asset allocation plan. These funds – and we’re talking about index funds tracking core fundamental benchmarks – add purity to investment styles.

Financial advisors can use index funds to hedge their bets and manage risk depending on the client’s risk tolerance. Some may want to focus more on active funds but have index funds as an insurance policy. Others use a “core and explore” approach where index funds form the core of their portfolio and they can choose active funds with varying levels of risk for higher returns.

Index Funds Track Indexes Perfectly

Another common misconception is that index funds mimic underlying indexes perfectly. While they do track them to a certain extinct, nothing stops fund managers from making adjustments. And these adjustments will not always replicate the sector exactly.

Even if index funds did reflect the underlying index perfectly, they would still not perform the same because of the fund’s fees. Managers may want to choose a smaller pool of companies, for instance. They may also use lower or higher levels of cash or proportion of companies’ size to mitigate the effects fees can have on performance.

Index funds are Passive

As we mentioned, index funds can be modified whenever a manager pleases. Benchmark selection is an active process, and you will have to actively monitor your assets when it changes. This also means that you have to understand the methodology and the construction of a fund before you make a decision.

The changes might be minor in some cases, but they can also be major, like a bias towards smaller cap companies, for instance. So, this should not be used as a forget-it vehicle and you will need to pay special attention to changes, especially if you’re investing in funds that use their proprietary benchmarks.

You can get an Idea of the Stocks in a Fund by its Name

You should never assume that you can tell what an index fund is about just by looking at its name. You have funds like the SPDR S&P Homebuilders fund that may sound like it’s centered around home building stocks. But, in reality, less than a third of all the stocks in this fund are in builders. This fund holds everything from stocks from appliance makers to makers of personal products like Helen of Troy. So, always take the time to delve deeper into a fund to know exactly what it’s composed of.

The S&P 500 Funds Only Own US Companies

While the S&P 500 wasn’t always reserved for US companies, all companies on the S&P 500 today are considered US companies by the committee. However, most of these companies are heavily invested in other markets. These companies will hold assets and conduct business denominated in foreign currencies.

This also means that their international operations will be affected by non-US laws and market conditions. This is particularly important in emerging and frontier markets. This means your portfolio will have some international exposure even if you track a purely American index.

Also, it would be wise to start familiarizing yourself with the indexes in your country and paying more attention to a domestic market you might be more familiar with. If you’re living in Canada, then we suggest you check this guide on how to buy index funds in Canada by Wealthsimple. You’ll learn everything from whether you should go for indexes closer to home or global ones, how to pick a trading platform and some of the benefits of index funds. They also explain some of the benefits of working with a robo advisor and the number of index funds you should consider investing in.

S&P 500 Index Funds Hold the Same Amount in all 500 Companies

This is another common false idea people have. In most cases, S&P funds are qualified as market capitalized weighted. What that means is that the fund will invest in companies based on their market capitalization. Market capitalization simply represents the number of shares that are owned by investors.

A fund that is market capitalized weighted will invest a lot more in say Exxon than it will in the smallest company in the index. However, some funds will invest equally in all companies in the S&P. One example is the Rydex S&P Equal Weight exchange-traded fund. The difference here is that much more money will be invested in relatively marginal companies.

If you want to know which one would be best for you, it really depends on your objectives. But, one thing is that most people invest in index funds to mimic the market, and equally weighted funds don’t do it as well as capitalized weighted ones. The most important is knowing that there is a difference between the two, so you’ll be better informed.

They’re the Perfect Protection Against a Bubble

People assume that because index funds are diversified by nature, they will shelter them against a bubble. However, this is not always true. For instance, about 30% of the S&P 500 was composed of tech stocks during the internet craze of 1999. So, those who thought they were safe from the NASDAQ’s meltdown also saw their assets diminish. Some of these tech companies were also some of the biggest in the index, and since they hold more weight on the benchmark compared to other stocks, the effect was even more pronounced.

This means that you need to diversify your index funds portfolio. You should also consider options besides the big indexes like the S&P.

Index funds are indeed a great way to manage your portfolio more passively and protect yourself from the volatility and uncertainty of investing in individual stocks. However, you should know that they’re not a completely hands’ off solution. You should also take the time to learn about both their risks and benefits before opting for them.

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