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 still some confusion about what they are and what they aren’t.

Perhaps the main benefit of index funds is their cost – their low cost, that is. When it comes to safety, index funds can be risky or safe (or somewhere in between). The particular index fund you choose determines how risky it is.

IHeartLowCostCost: investors in index funds pay less than investors in actively managed funds. Why? Index funds are passive investments: you don’t pay a manager (or a team) to decide which investments to buy and which ones to sell. Instead, an index fund is designed to behave just like “the market,” or 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).

Tracking the 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?

Perhaps because of their popularity, index funds are sometimes perceived to be the safest way to invest. They have certain benefits, but index funds are not necessarily safe investments (at least, they’re not any safer or riskier than any other type of mutual fund).

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 (people often refer to this as “the stock market”)
  • 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 no such thing as a safe stock. In late 2008, the S & P 500 was down just over 45.5%, and every 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. They’ll also participate when markets are strong.

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. For example, high-yield bonds (also known as “junk bonds”) pay higher interest rates because there’s a better chance that you’ll lose your money, and those bonds are what you’ll find inside of high-yield bond index funds.

Compared to What?

Given the statements above, you might be tempted to believe that index funds are unsafe. However, they’re not any more unsafe than actively managed investments. 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 or some Aggregate Bond Index. There are index funds that invest in a broad variety of investments, and doing a little homework might help you build a diversified portfolio that works in a variety of markets.

Which Index Funds are Safest?

So you still want to know what to pick? By now you realize there’s no simple answer, and it will depend on what you mean by “safe.” There is always a tradeoff: picking one kind of safety means taking a different kind of risk. Assuming you want to take more risk than a bank account:

  • If you want to minimize market risk, look at conservative or high-quality bond index funds
  • If you want to avoid losing money in bonds when interest rates rise, use shorter-term bond funds
  • If you want to avoid losing purchasing power over several decades due to inflation (“going broke slowly”), use diversified stock funds or asset allocation funds — but now you’re back to taking market risk

When most people search for the safest index funds, they’re probably looking for short-term, high-quality bond funds. Those are less likely to suffer significant losses during market events. But they might not keep you safe from inflation.

The Devil in the Details

If we’re willing to keep things simple, this much is true:

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 don’t 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 and ignoring the gains — that’s what most people do)
  • On the other hand, the largest companies can skew cap-weighted index funds, so activity in a few popular stocks might make index funds perform differently than a diversified active fund
  • Depending on what you want to call “risk,” you risk paying more short-term capital gains and trading expenses in an active fund
  • Depending on what types of funds you want to allow into any comparison, and what time frames you choose to look at, active funds with hedging operations (currency or basic options, for example) might do better or worse than passive funds

When academics talk about the risk of actively managed funds, they’re probably not talking about what you think they’re talking about (the risk of losing money). Instead, they’re referring to the danger of picking a manager that underperforms the index. Index funds eliminate that risk: you’re simply going to get whatever the market does.

Photo credit (I Heart Low Cost): Herederos de Rowan