Index Fund Investing: Is This Strategy Too Big or Inefficient?

NEW YORK (MainStreet) — The rising popularity of investing in large capitalization index funds has left some experts wondering if the strategy is becoming too big or inefficient.

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Index funds have been popular among retail investors who prefer the ease of following a targeted industry benchmark such as the S&P 500, Dow Jones Industrial Average or the Russell 2000 rather than identifying a fund manager who can pick winners consistently despite all the fees.

Portfolio managers who buy and sell assets in a fund to deliver the same return as an industry benchmark are following a passive investment strategy compared to active managers who chose stocks based on their performance.

“Investors want to know if we're entering a period where actively managed investment strategies could be more advantageous,” said Chris Philips, a senior analyst in the Vanguard Investment Strategy Group, in a blog post.

The growth in indexing could result in more assets being allocated to passive investments and could lead to a scenario where the strategy has become “too big,” because the market could operate more efficiently, he said. The market could provide more opportunities for active investors to profit.

The surge in the popularity of index funds remains, because investors can avoid the risk involved with picking individual stocks that can damage their portfolio, said Jesse Barkasy, a portfolio manager with Covestor, an online investment management company with offices in London and Boston.

“For the above average investor, index funds can be very profitable,” he said.

While indexing remains very popular, the amount of money invested in index funds remains far behind that of active management. Index funds and exchange-traded funds (or ETFs) constituted 35% of equity funds and 17% of fixed income funds in 2013, said Philips. When it comes to total dollar market value, index funds constituted 14% of equity market value and 3% of fixed income market value. Active management such as hedge funds, individual securities or managed accounts still outranks passive management - 85% of the equity market and more than 95% of the bond market are invested in some form of it, he said.

“Prices are set and continuously reset by active investors seeking to profit from their knowledge and beliefs,” Philips said. “Indexers, on the other hand, attempt to passively track the market at the prices set by those active investors. Even if active investors only made up a very small portion of the market in terms of invested dollars, as long as some profit motive existed, they would still be competing with each other for an opportunity to make a gain.”

Large index funds which have a high amount of average trading volume decreases the risk for investors, said Barkasy.

“If someone wants to invest in a smaller less liquid fund, I suggest they take a smaller position and spread their investment dollars among several of those less liquid index funds at different times of the year to quell potential risk,” he said.

Index funds have a “very structured way of investing” and have not become too big or inefficient, said Bijan Golkar, vice president for FPC Investment Advisory in Petaluma, Calif. Since they do not “reinvent the wheel,” investors receive “consistent exposure without having a manager in there trying to mess it up or charge high fees,” he said.

The low internal expenses and tax efficiencies benefit investors who also want to understand what they are investing in, Golkar said.

“If nine out of ten money managers cannot beat the market, what makes you think you can choose the one that does?” he said.

Investing in index funds remains a good strategy, because it does not depend “upon the vagaries of the market,” said Robert Johnson, CEO of The American College of Financial Services in Bryn Mawr, Penn.

“I think there is as compelling a case to invest in index funds now as ever before,” he said. “For most Americans that means dollar cost averaging into equity mutual funds. Those who pursued a dollar cost averaging strategy from the financial crisis through today have been rewarded handsomely.”

The growth of index strategies is not likely to decline because investors “overwhelmingly seek out the lowest cost investments,” Philips said.

“Lower costs help clients keep more of a fund's return and are a big factor influencing relative performance,” he said. “Even though index funds generally underperform their target benchmarks, low cost index funds have displayed a greater probability of outperforming higher cost actively managed funds.”

Indexing may not impact how a market operates since the performance of active managers has not risen, Philips said.

“In other words, if the rise of passive funds were leading to inefficiencies, theoretically active managers would have an easier time outperforming a relevant index,” Philips said. “However, as the dollars allocated to passive investments have increased, the relative performance of active funds hasn't improved.”

All index funds were not created equal and do not have the same performance. Investors who stray into investing in more esoteric assets classes such as junk bonds and commodities should expect more volatility to occur, said Johnson.

“The underlying securities don’t change very often and can be subject to extreme swings in value,” he said.

Individuals should avoid making large adjustments to their asset allocations in anticipation or response to market conditions such as interest rates rising since most individuals follow a herd mentality and are “greedy when others are greedy and fearful when others are fearful,” Johnson said.

Timing the market is tricky and requires investors to know when to get out of the market and when to get back into it, he said.

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“For individuals building wealth over the long run, the most prudent way to build wealth is through dollar-cost averaging by consistently putting money into the stock market each and every month,” Johnson said.

Choosing a fund manager who can pick winners after all the management and other fees have been paid is not simple.

“The evidence is overwhelming that the vast majority of investment managers cannot beat the market after fees,” Johnson said. “Index funds give you broad exposure at a low cost with little turnover. That is a tough formula for an active manager to beat.”

Rebalancing a portfolio consisting of index funds is still critical, said Golkar.

“You still need to make sure you are taking a proper amount of risk,” he said.

--Written by Ellen Chang for MainStreet.

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