When Do Index Funds NOT Make Sense?

This is a bit of a weird question. After all, index funds are probably the right choice for most investors, most of the time. This is particularly true if you are light on investment experience, or if you prefer investments that are relatively passive.

Still, there are times when index funds do not make sense, and here are a few examples.

If You Are A successful Stock Picker

If you are an experienced investor, with a long track record of picking stocks successfully, you’ll probably find index funds to be a little bit…boring! And for you, they will be. Let’s face it, with index funds you make your investment and then step back and let it happen. That’s perfect for a passive investor, but if you can beat the market averages in most years, you’ll probably feel as if you are losing money by investing in index funds.

Admittedly, very few people can beat market averages on a consistent basis. But if you’re one of the few, index funds will only work if you are looking for some time to kick back and take it easy.

When The Stock Market Is Range Bound

Index funds are a brilliant investment in rising markets. You don’t have to pick individual stocks, figure out which sectors will outperform the market, or even pay a lot of attention to your investments. You buy into index funds, get into the elevator, and ride it up.

Perfect.

But when the stock market is range bound – when it’s movements are essentially no better than sideways – index funds will be a road to nowhere.

In a range bound market you’ll be far better looking for specific sectors that are rising. Energy funds might be a good example, since the same factors that would cause them to rise might also cause the general stock market to stagnate. You can make far more money investing in energy funds if that is the case. And energy funds are just one such sector.

When The Stock Market Is Looking Top Heavy

When the stock market looks like it’s getting nose bleeds, index funds could be one of the worst places to be. The upside potential is very limited, but the possibility of a slide is much greater. Should the general market begin to fall, index funds will go down with it.

In such a market it might be difficult to identify a sector that will outperform the market and continue to rise. But you can always go to cash, which will protect your portfolio from impending market declines. In a declining market index funds will lose value, while cash will preserve it. Then when the market seems to be bottoming out, you’ll have plenty of cash to move back in index funds for the ride up.

When Interest Rates are Rising

Rising interest rates usually have a negative effect on the stock market, and that includes index funds. Since interest-bearing assets compete with equities for investor capital, rising interest rates will generally cause a move out of stocks and into interest-bearing investments. The exodus from stocks will make index funds a poor investment.

In a rising rate environment, you’ll be better off in money market funds, very short-term bonds and any other instruments that are likely to benefit from rising interest rates. For what it’s worth, longer-term notes and bonds won’t do much better than stocks and are best avoided too. Rising interest rates can also cause longer-term interest-bearing securities to drop in value. The longer the term, the greater the potential drop.

If You Are Completely Risk Adverse

If you’re looking for low risk investments, index funds aren‘t the place to put your money. Index funds may have lower risk than actively managed funds and most sector funds, but they are hardly risk-free. A 50% fall in the market to which your index fund is attached will cause a corresponding 50% drop in the value of your fund.

If you prefer low risk investments you will be better off investing in certificates of deposit, bonds, and high yield dividend stocks, such as utility stocks. The income provided by the securities will keep them from falling as dramatically as the general stock market.

Index funds are not the all-weather, widows-and-orphans type of investments we sometimes like to think they are. They are an excellent hold for investors who are looking for growth with an average appetite for risk. But for investors who want something more dynamic, or those are more risk adverse, or in certain types of market environments, index funds may not make much sense.

Readers: Do you agree or disagree? Do you know of any other situations in which using index funds doesn’t make sense?

Comments

  1. Brick By Brick Investing | Marvin says:

    I would fall in the first category. I like making my own picks and not letting someone else manage my money for me. I plan to build a significant dividend portfolio overtime and with the knowledge that I have I believe I can beat any ETF over the long haul.

    • Michael says:

      Brick, do you have any numbers, like how much alpha? Are you killing it? Are you factoring in trading costs, taxable events?

      For the last 10 years most lazy portfolios have done around 8% annualized. See http://www.marketwatch.com/lazyportfolio

      The S&P has done 6.79% which is the typical stock market “benchmark”. I might add that these portfolios are completely passive, requiring no thought (debatable on if that is good or bad).

      • Brick By Brick Investing | Marvin says:

        Michael

        Sorry for the delayed response. The problem with “lazy portfolios” is they don’t focus on providing what retirees need most, income. You simply have X amount of shares that are worth X amount of dollars. The fund may provide a dividend but it is miniscule compared to what it could have been had the individual focused on dividend focused equities.

        Because I am purchasing these equities in my retirement account I don’t incur any taxes and I do not pay any managerial fees like most funds. Additionally I use low risk option strategies to increase my returns significantly, around 20-25% annually.

        Depending on ones aptitude and willingness to actively manage their portfolio a passive approach may be best for that particular investor. For me however, I love trading and having control of my portfolio.

        • Michael says:

          Brick,

          Let’s make sure we are framing these returns correctly. When you say increase your returns annually are you saying 20-25% overall or increased by 20-25%, i.e 10% + (2% or 2.5%) .

          I would like to offer some counter points if your returns are the latter.

          All money that come out of your 401K (Assuming not a Roth) with be taxed at 28-35% most likely. A lazy portfolio in your taxable account will grow at 10% (text book returns of market, but I think we all agree this is closer to 8%). and will ultimately be taxed at only 15%, almost 50% less than the 401K. So keeping that in mind your returns in your 401K would have to outpace the lazy portfolio by quite a bit to make up for the tax disadvantages.

          Assume you turned 59.5 and your retirement account was 100k (work with me, I know its a low number but this is an example). You take out the full 100k. In your 401k your net payout would be 70K after taxes vs 85K with a taxable account. All this to say that equities in your 401k has already put you in a significant tax advantage.

          Let’s say your first contribution to the 401k and taxable account were 10K each. On the 401k you would get 3K back on your taxes. After 24.15 year both accounts will be around 100K. You can see taxable accounts with long term capital gains beat the 401k handily . All this to say, you need to pay special attention to taxes, the largest destroyer of wealth in your 401k when you take money out. The 401k is not the place for a lazy portfolio, or in opinion equities at all really. I have no bonds in my taxable accounts, I keep them all in my 401k where I can reduce fixed income taxes to 0% while it grows. This tax engineering alone adds appreciably to ROI.

          Secondly, with respect to income. I don’t think its is particularly the fault of lazy portfolios, more so an issue with the insane Fed policy that insists on systemically extracting wealth from people with real negative returns after inflation. But to counter your point about going after dividends, there are many ETFS, like VIG, that seek dividends stocks. Also, many investors are being forced into dividends because of CDs/MMAs paying nothing. I could see a serious outflow of dividends stocks once the Fed is forced to raise interest rates. I think it’s clear by the fact VIG is already past 2007 highs that investors are all seeking dividends for now.

          By using a lazy portfolio and owning the entire stock/bond market I can take advantage of asset class correlations and reduce risk thus increasing returns with little to no thought. I’m a big fan of lazy portfolios. I think they have many advantages that are not clear . They are also very boring which does not appeal to many. I would be lying if I said I didn’t have money set aside to “play” with.

          Brick, if you are interested in fixed income you should look at my website, Nickel Steamroller. Larry does updates on his p2p portfolio. I think it would be wise to consider at least a small position in p2p loans to hedge your dividend stocks.

          • Brick By Brick Investing | Marvin says:

            Michael

            Thanks for the response. I actually make between 12-18% on my portfolio a year trading options and reinvesting my dividends. I will definitely take a look at your website. I took the plunge into P2P back in 2007 but got burned, I have noticed a lot of regulations have been put in place since and may give it another chance.

    • Michael says:

      Additionally, are a majority of your trades short to long term capital gains? If you beat ETFs which will typically be taxed at 15% (due to longer holding and low turnover) vs 28%+ you will have to increase returns quite a bit if you are going to beat ETFs. Unless you are doing this all in a tax sheltered account.

      • Larry Ludwig says:

        Michael, I agree if are going to do short term trading, putting doing them in some retirement account is the way to go. Taxes aren’t an issue (at least before retirement).

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