Index funds have a fundamental flaw that is pointed out from time-to-time — they tend to get unbalanced, allowing a few hot stocks to dominate the index. This can be a flaw in that they will tend to be subject to bubbles. For example, the NASDAQ Index was hit especially hard by the technology bubble in the late 1990s.
To understand why this occurs, first one needs to understand how index funds are made. To create an index, one simply selects a group of stocks and buys equal dollar amounts of each. At the beginning, everything is balanced. If stock XYZ goes up 1% and stocks ABC goes down 1%, the value of the index will stay unchanged.
Over time the index gets unbalanced. If stock XYZ goes up 50% while everything else remains the same, if you buy in at that point you will buy a greater dollar amount (50% more) of XYZ than you will buy of the other stocks in the index. Because XYZ has gone up a lot, you are now buying more of the stock that is higher in price (and therefore, you assume, high in price compared to a fair valuation) and less of those stocks that are lower in price. You are buying high and selling low.
Despite these flaws, there are still many reasons to buy index funds instead of managed mutual funds:
1. Index funds have much lower fees than managed funds. Index ETFs have even lower fees.
Index funds typically have fees of 0.25% or less, compared with 1-3% for managed funds.
2. Most managed funds will not outperform index funds over long periods of time.
While there are some managers who have a hot streak for a while, those higher fees catch up with manged funds eventually. Also, people tend to pile into the best funds, which forces the manager to find places to invest all of that extra cash. Eventually they end up buying so many different stocks that they do just as well as the market before their higher fees.
3. Buying more of the winners isn’t always a bad thing.
Usually some stocks outperform others for a reason. They are well-managed, they have a good product line, or they have room for growth. While buying stocks when they are high is not a good strategy, some stocks have enough earnings growth so that you really aren’t buying that high.
4. A lot of people buy index funds, so there is a lot of support for the stocks in them.
Virtually every fund company has a S&P500 fund, a Russell 2000 fund, and an index fund for each other index that is in existence. Every 401k plan has the same funds as well. As long as there are lots of people investing in these funds, there will be support for the prices of the stocks in the indices.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.