Ever since index tracking funds overtook active funds in popularity with UK investors more than two decades ago, there has been a continuous debate over which approach is better. But while index funds are an essential investment tool, we don’t believe they should be replacing active funds just yet.
What is an index fund?
As the name suggests, an index fund is an investment created with one objective in mind – to track the performance of an index. An index fund is also known as a passive investment because there are no active investment decisions to be made. For example, a FTSE 100 index tracking fund will feature the same 100 companies as are listed at any given time on the FTSE 100 index. Should the companies featured in the FTSE 100 change, so too will the companies featured in the index fund.
Why choose an index fund?
There are several reasons why it makes sense to invest in an index fund. Firstly, an index fund is a relatively inexpensive way for an investor to gain exposure to a particular asset class or market. Because there are no fund manager salaries to pay, the cost of owning an index fund is considerably less expensive than the management fees you would expect to pay for owning an actively managed fund.
Second, an index fund will invariably cost less in transaction charges. While an active fund manager is free to buy and sell investments as often as they think is suitable for their portfolio, an index tracking fund will only buy and sell when index constituents are reshuffled (as an example, the companies in the FTSE 100 are reviewed every quarter to determine whether they still merit a place in the index).
Finally, investing in an index fund is a good way to invest if you plan on staying invested for the long term, or if you don’t want to keep actively monitoring your investments regularly. You can simply buy shares in the index fund and hold them for as long as you choose to.
What are the disadvantages of index funds?
While index funds definitely have their advantages, there are some important disadvantages that investors should also be aware of.
Underperformance
The first is that index funds – by their very nature – will only ever deliver an underperformance. That’s because passive investments are not designed to beat the performance of the market they focus on, they can only track it. And, when you add in the cost of investing in an index fund, this means it will always fall slightly short of the market’s returns once those fees are paid. The advantage of an active manager is that their goal is to outperform the market they invest in, by making decisions – but of course, attempting to achieve greater rewards carries greater risk too.
Lack of protection during the bad times
If you’re invested in an index fund, your investment is heavily dependent on the fortunes of the market your fund is invested in. While stock markets have proven to be a good investment over the long term (by this we mean at least ten years), they can be much more volatile over shorter periods. Investing in an index fund means that your investment will do well when the market is doing well, but will invariably suffer when markets are facing difficult conditions.
Lack of choice or control over the investments you hold
An index fund is a ready-built portfolio featuring all of the constituents of a particular market or index. So, if you own a FTSE 100 index fund, this means you own a small percentage in 100 different companies. You have no control over the companies you ‘own’, and you do not get a say on whether you believe those companies are in line with your personal principles or not (tobacco companies, oil companies, or weapons manufacturers, for example). The components of any index fund are effectively out of your hands.
Lack of flexibility
Another point worth mentioning is that investing in an index removes the opportunity for ‘advantageous behaviour’ or what is known as “buy low, sell high”. The downside of owning an index fund is that if a stock within the index becomes overvalued, it starts to carry more weight within the index, and your fund will be forced to purchase more of it, at the higher price. So, even if you have a personal view that a particular stock is overvalued or undervalued, by investing solely through an index fund, you do not have the ability to act on that knowledge, and nor can a fund manager do so on your behalf.
Here is an interesting example of how index investments can sometimes work against investors. When Tesla was admitted into the S&P 500 index in November 2020, within a matter of weeks it had already overtaken Facebook to become the fifth-largest company in the index. Once it gained entry into the S&P 500 index, every S&P 500 Index tracker automatically had to include Tesla as a new constituent, and this ‘forced buying’ helped to propel the Tesla share price upwards.
Why is this important? Well, Tesla had been close to gaining entry to the S&P 500 previously, meaning that many active fund managers made big profits by owning Tesla shares bought in advance knowing that once it entered the S&P 500, index tracking funds would have to start buying the shares at inflated prices. In the case of a company like Tesla, active fund managers had the maneuverability to make a smart rational decision, and this left them able to make a profit at the expense of index funds and, ultimately, their investors.
Overview
The debate over whether active or passive funds offer the best value for investors will no doubt rumble on. But investors do not need to see it is a decision to adopt either one approach or the other. A better way is to consider them both as valuable tools that deserve their place within a well-built investment portfolio. We believe that holding a blend of both actively managed funds as well as a carefully chosen selection of index tracking funds, is the best way to build a well-balanced, cost-effective, and risk-managed investment portfolio.
If you are interested in discussing your investment portfolio with one of the experienced financial planners here at FAS, please get in touch here.
This content is for information purposes only. It does not constitute investment advice or financial advice.
