While index funds cost less than actively-managed mutual funds and they are both “diversified” we think index funds have some surprising drawbacks.
Consider these four important disadvantages of index funds:
1. Index funds may not provide as much diversification as one thinks. Nortel’s weighting within the TSX (Canada’s main stock market index) grew from an initial 3% to over 30% over time! Many investors were unknowingly exposed to undue risk through the index’s concentrated exposure to one single technology stock which subsequently went bankrupt.
2. Owning a passive index means necessarily owning everything in that index. No one is paid to distinguish between stronger and weaker companies or to decide to overweight or underweight sectors depending upon economic and market conditions.
3. Index funds lack strategies to limit volatility. Therefore, index fund investors have to attempt to time markets or accept they will suffer the full downturn. In contrast, active mutual fund managers can use tactical and defensive strategies to mitigate some of those risks and help investors to stay invested.
4. Swings in the value of an account should decrease as one gets closer to initiating a program of receiving regular income from investments. Index funds cannot attempt to make adjustments to your portfolio to help smooth out payments nor provide diversification by management style.
If you have any questions about how we carefully select and combine the world’s best mutual fund managers to properly diversify portfolios, please give us a call.
