The Downside of Index Funds

By on January 14, 2011

Dan Caplinger, at The Motley Fool, points out a weakness of index funds, particularly large cap index funds like the S&P 500 and Dow Jones Industrial Average:

But it’s important to understand that when you buy an index like the S&P 500, you aren’t investing in a completely passive way. Standard and Poor’s, which manages the S&P 500, makes changes to its benchmark index from time to time — and some of those changes have turned out to reflect some really bad timing.

For instance, consider these ill-timed moves:

•  In 2000, the S&P 500 replaced many old-economy stocks with up-and-coming tech names Broadcom (Nasdaq: BRCM) and JDS Uniphase (Nasdaq: JDSU), among many others. It also added utility Dynegy (NYSE: DYN) in the wake of the deregulatory fervor that eventually led to Enron’s demise.

•  More recently, after kicking Ingersoll Rand (NYSE: IR) out of the S&P 500 in early 2009 in favor of Quanta Services (NYSE: PWR), S&P returned it to the index in November. During the time it was out of the index, Ingersoll Rand’s stock almost doubled, while Quanta lost nearly a quarter of its value.

When you think about it, it makes sense that the S&P 500 would typically involve buying high and selling low. After all, a company won’t be eligible for inclusion in the index until it grows to a certain size, so you’ll automatically have missed the best high-growth period that the stock went through to reach large-cap status. Similarly, once it’s in the index, a stock may well have to fall a long way before it gets so low that Standard and Poor’s tosses it out of the index.

Nor is Standard and Poor’s unique in its decision-making prowess. The Dow Jones Industrial Average has had well-documented bad timing in some of its choices. Adding big tech names at the peak of the bubble was an obvious mistake, but even in the run-up to the financial crisis, the Dow made questionable calls.

Adding Bank of America (NYSE: BAC) in early 2008 proved disastrous for the index, as the bank stock was hit hard during the market meltdown. But then the Dow waited until after the market’s lows to evict Citigroup (NYSE: C) from the average, exposing investors to nearly the full downturn in the bank’s shares.

Caplinger fairly reveals the benefits of indexing which is why they should still be considered a core investing strategy:

Despite their flaws, index funds still have clear benefits. Given how few active fund managers manage to outpace benchmarks like the S&P 500 over the long haul, even the shortcomings of the companies that manage those benchmarks seem less detrimental than bad investing decisions of many fund professionals.

Never think, however, that an index is the end-all-be-all of investing. As a tool, it can serve you well, but you shouldn’t be scared to venture beyond it seeking your own outperformance. After all, even index funds do dumb things sometimes — and will continue to do so well into the future.

Source: The Motley Fool

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