Are Index Funds Safe?

Index funds are popular investments, and they are widely touted as the best type of investment to use. To be sure, they’re quite good. But there’s some confusion out there around what they are and what they aren’t.

Perhaps the main benefit of index funds is their cost – their low cost, that is.

IHeartLowCostInvestors in index funds pay less than investors in actively managed funds. Why? Index funds are passive investments: there is no manager trying to decide which investments to buy and which ones to sell. Instead, an index fund is designed to behave just like a basket of investments that have been grouped together. Presumably those investments were grouped together based on some common characteristic (for example, they’re all companies with a large market share in the United States, which might describe the S & P 500 Index).

Buying an index fund allows you to invest in something that behaves more or less like the index it’s based on – no better, no worse.

Safety in Index Funds?

A major misconception about index funds is that they are safe investments. I’m not sure how this got started. Perhaps it’s because it’s fashionable to tell people that they only need to know one thing about investing: buy an index fund. The notion is dying, but it’s still out there.

The fact is that things are more complicated than that. While they have certain benefits, index funds are not safe investments (at least, they’re not any safer than any other type of investment). It’s better to learn this by reading about it now than by getting a nasty surprise when the market crashes.

Index funds invest in whatever their underlying index is composed of. A few of the most common indices used in index funds include:

  • S & P 500 = large US companies
  • MSCI EAFE = companies located in developed nations of Europe, Australasia, and the Far East
  • Wilshire 5000 = almost all stocks traded in the United States
  • Barclays Capital Aggregate Bond Index = investment grade bonds traded in the United States

As you can see, index funds can invest heavily in stocks, and almost any investment in stocks is risky – there’s really no such thing as a conservative stock. In late 2008, the S & P 500 was down just over 45.5%, and any S & P 500 index fund should have been down just about as much (any minor difference would be due to tracking error and dividend payments). Granted, 2008 is extreme, but index funds will participate in any market downturn whether large or small.

What About Bond Index Funds? Safe?

Even “safe” investments like bond index funds can lose money. Investments tracking the Barclays Aggregate Bond Index were down 3.63% in September of 2013. That’s not a huge loss, but it might be surprising if you think that bonds + index funds = safe investing. The reason for that loss was a rise in interest rates, but bonds can lose value for other reasons as well.

Compared to What?

Given the losses above, one might be tempted to believe that index funds are unsafe. However, they’re not any more unsafe than actively managed investments. I’m too lazy to look up more numbers, but you can safely assume that plenty of active funds lost 45% in 2008 (give or take a few percent or more, depending on the fund’s objective). Likewise, there was no shortage of actively managed bond funds down at least 3.63% in September of 2013.

The point here isn’t to compare active and passive strategies (yes, it’s taking a while to get to the point), but rather to make sure you understand that index funds aren’t necessarily safe investments. You can lose money if the underlying index goes down. Since many of those indices are financial markets, you should expect them to go down from time to time.

Managing Risk

If you want to keep your money safe, you’ll have to decide what you’re willing to give up. The safest place for money is of course in a bank account (assuming all of your money is insured by the FDIC). But if you want to go for more growth using index funds, you’ll have to make the classic investment decisions:

  • How much to invest in stocks vs. bonds vs. cash
  • How much to invest in US, developed, and emerging markets
  • What types of bonds to invest in (government, foreign, corporate, or junk? Short-term, floating rate, or longer-term?)
  • What types of stocks to invest in (large, small, US, foreign, emerging market, etc?)
  • Any other types of investments you want exposure to (assuming you want to use index funds, and that index funds are available in those categories)

Unfortunately, managing your risk is a complicated matter, and it takes a little more thought than just buying an S & P 500 index fund and/or some Aggregate Bond Index. There are index funds that invest in a variety of investments, and doing a little homework might help you build a diversified portfolio that works in a variety of markets.

The Devil in the Details

If we’re willing to keep things simple, I’ll say this much:

When it comes to market volatility, index funds are not more or less risky than actively managed funds.

But the Devil is always in the details. Many people might not care about those details, but a few complications that come to mind are:

  • An actively managed fund might be more concentrated than an index fund, and losses in one of its holdings could make it more volatile (when we talk about volatility, we’re really just talking about the losses…)
  • On the other hand, the largest companies skew cap-weighted index funds, so activity in those stocks might make them perform differently than a diversified active fund
  • Depending on what you want to call risk, you risk paying more short-term capital gains in an active fund
  • Depending on what types of funds you want to allow into any comparison and what time frames to look at, active funds with hedging operations (currency, or other market movement for example) might do better or worse than passive funds

 

Photo credit: Herederos de Rowan

Comments

  1. I like index funds for two reasons: lower cost and limited human involvement. Certainly “some” managed funds could do better than “some” index funds, but generally we have no ability to know which in specific cases. I’m a big fan of keeping the humans out of it and letting the algorithms do the work for me.

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