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The good, the bad, and the ugly of investing in index funds

Index funds have become a major force in the investing world. What, precisely, does this mean and why should new investors care? What are the benefits of investing in index funds? What are the drawbacks? These are some of the most important questions you’ll face inbesting that better investing index are going lnvesting need to seriously give index funds a look, especially if you are a smaller investor of modest means. In the next few minutes, I want to walk you through how I think about index funds — the good, the bad, and the ugly — to help you gain some perspective.

The BetterInvesting 100 Index (BIXX), reflecting the portfolios of Main Street investors, fell 7.5% in May.

Tax Saving Plan. Young India Plan. Updated on Nov 27, — PM. An index fund is a mutual fund that imitates the portfolio of an index. These funds are also known as index-tied or index-tracked mutual funds.

The BetterInvesting 100 Index (BIXX), reflecting the portfolios of Main Street investors, increased 1.8 percent in March.

Index funds have become a major force in the investing world. What, precisely, does this mean and why should new investors care? What are the benefits of investing in index funds? What are the drawbacks? These are some of the most important questions you’ll face considering that you are going to need to seriously give index funds a look, especially if you are a smaller investor of modest means.

In the next few minutes, I want to walk you through how I think about index funds — the good, the bad, and the ugly — to help you gain some perspective. An index doesn’t actually exist in a sense. Rather, it is an academic concept; an idea. Basically, it amounts to a person or a committee of people sitting down and coming up with a list of rules as to how to construct a portfolio of individual holdings because, in the end, the only thing you can actually do is invest in individual common stocks or bonds vetter, presuming we’re limiting our discussion to equity and fixed income markets.

For example, the most famous ijdex of all time, the Dow Jones Industrial Averageis a list of thirty blue chip stocks. This list is to be made up of a representative collection of stocks that are important to the economy of the United States. The shares are weighted based on stock price and adjustments are made for indsx such as stock splits. Historically, the DJIA has been highly passive as changes are somewhat rare.

Short for the Standard and Poor’swhich was originally called the Composite Index when it introduced its first stock index in It expanded to 90 stocks inbefore expanding to its current count in of At some point, you enter a Ship of Theseus paradox and you have to wonder, at what point you are dealing with an entirely different thing. In any betterr, an index fund is simply a mutual fund that, instead of having a portfolio manager making selections, outsources the capital allocation job to the individual or committee determining the index methodology.

In the end, you still own a portfolio of individual betteg, it’s just held in a pooled structure with a portfolio manager over it who is responsible for getting results as close to the index as possible known as «tracking».

Index funds have a lot of advantages, especially for poorer investors, which is one of the reasons I’ve lavished a lot of praise on them over the years. Firstas long as the investor realizes there is nothing magical about the word «index» — there are good indices, bad indices, and mediocre indices — and selects an intelligent underlying index run by a stable and responsible asset management companyit should provide a satisfactory way to participate in whatever underlying market it represents with a single purchase.

Secondmany index funds in the equity market tend to be run in a way that minimizes turnover. Low-turnover, or high passivity depending upon how you prefer to phrase it, has long been a key to successful investing. In fact, there is ibdex tremendous body of research that shows investors would be better off in many cases buying the underlying index components directly, as individual stocks, and sitting on them with no subsequent changes at all than they would be by investing in the index fund.

These ghost ship portfolios, as they are sometimes known, require a specific type of psychological profile but the rewards over periods of 25 to 50 years can be astounding. You don’t have to worry about methodology changes and you have much better tax planning flexibility should you need to raise cash.

Thirdindex funds tend to have lower mutual fund expense ratios than other mutual funds. This can add up to real money over time if you aren’t fortunate enough to have a large portfolio with the requisite scale to take advantage of other opportunities and planning strategies. In fact, it doesn’t even cover the minimum fee at many of the white-glove, well-heeled asset management groups that build portfolios for the affluent and high net worth investors.

There can be a lot of utility for a person in that situation, especially someone who isn’t good with money and doesn’t have more than a couple of decades to live so the fee differential doesn’t have a huge compounding period to expand upon itself in terms of opportunity cost. In fact, it’s a good general rule of thumb for any young investor of modest means investing through a k plan at work to almost always opt for the low-cost, highly passive index fund over any of the other offerings available to him or.

It’s how to handle assets if they are stuck within a retirement plan at the place of employment. Fourthindex funds have an enormous psychological advantage for people who are not inherently good at math.

Do not underestimate how incredible this can be in saving a family from financial hardship and ruin due to its influence on behavior. A lot of men and women, who otherwise might be intelligent, good people, lack a basic grasp on how numbers interact. To demonstrate it, take the so-called bat and ball question.

It’s wrong. They don’t get that individual components can compound at a lower rate, on average, than the overall portfolio or that several bankruptcies of different holdings along the way can still result in inveeting returns.

The index fund solves this because it serves as what I’ve called an obfuscation mechanism. It hides the returns of the underlying components so investors don’t have to think about. Rich investorssophisticated investors, they don’t need this sort of mind investin. They own the stocks directly. In this way, the index fund can help encourage investors to hold on longer than they otherwise would have, thinking about their total portfolio and not investong underlying better.

There is a meaningful danger in this approach, though, in that if methodology changes cause the underlying holdings to be less bettsr stellar, ultimately, that will harm the investor. Fifthindex funds, by nature of being diversified already, diffuse the dangers of investors who suffer from a cognitive bias called irrational escalation. You wouldn’t believe how often I’ve watched ordinary people who are smart in all sorts of areas throw their life savings into a company they don’t understand based on the most ridiculous justification.

On the flip side, there are several major disadvantages of investing in index funds. These become more pronounced the more successful you are.

First, you need to understand that index funds are a crude approximation of the thing that makes them work. They are not ideal, they are simply «good enough». When you look at the underlying academic evidence, it is overwhelming in demonstrating that, historically, success most frequently arises for investors who:. For lower and middle-class investors, the index fund was the only way to achieve that if you didn’t want to devote a lot of time to your portfolio.

As a matter of fact, it’s not even close. No intelligent person would have picked the public index fund over a privately constructed index fund made up of the individual securities held on an equal-weight basis after seeing the data if he or she beetter afford the costs. Jeremy Siegel and his researchers at Wharton have demonstrated this beyond any potential disagreement so arguing ivnesting it is like advocating for the Flat Earth Society.

The numbers are crystal clear and irrefutable. It can be done at very little additional cost provided the investor has the requisite scale.

In fact, John Bogle himself attempted to get Vanguard to offer such a service several decades ago before the management that ultimately forced him into retirement due to his age rejected the idea as too much work for the firm. Bogle was correct — the tax consequences for wealthy investors are important enough, leaving aside the equal-weight-versus-market-weight advantage entirely, investibg it’s still better to own the underlying components directly.

Between the risk of embedded gains, which I’ll touch on a bit in a moment, and the ability to tax lot harvest when needing to raise funds, the advantage becomes shocking as time passes and compounding works its magic. Rather, it is only a way for those without sufficient scale to take advantage of. It’s second best. It was never meant for the rich, who, if they desire to index, should be running a private index fund on their.

How much would it take to justify building your own private index fund rather than investing through befter pooled public index fund? Good question. A quick glance around most white-shoe firms indicates you could probably get it done for between 0.

Due to the ability to tax-loss harvest and having assets more equally spread out, there’s a good chance over 25 to 50 years, you’d be not just better off, but a hell of a lot better off despite the modestly higher fees due to superior portfolio construction methodology of your investig index account than you would be with the public index fund.

Even more unfairly, the richer you are, the bigger the advantage. Split-offs will occur. Tender offers will be extended. Proxies will need to be voted.

The paperwork mailings alone could bury your living room. Another potentially better investing index issue with wealthy investors holding certain index funds that nobody wants to talk about, and even if they do, refuse to believe the same way folks ignored the dangers of dot-com stocks and collateralized investiny obligationsis the risk of embedded capital bettter. If Vanguard were to experience a significant run on the fund for whatever reason — and these things have, do, and will happen — management could be forced to liquidate those positions or, at the very best, pay them out «in kind».

This is something Vanguard investors have never had to consider because as indexing has become the latest fashion, it has been able to pay redemption requests with fresh deposits a lot of times, net assets growing in the long-run.

Should that stop, it could get ugly. You also may not care about it if you plan on donating most of your estate to charity and your spouse is only a few years younger than you with a inveesting expectancy that is nearing its end. Warren Buffett is a good example. However, Buffett will almost certainly have this put into some sort of charitable annuity trustmost likely organized by Munger Tolles, which itself mitigates almost all of the tax risk.

Even if he didn’t, given the large amount involved, and the likelihood of end-of-life arriving in short order, the trade-off isn’t worth building a portfolio directly as he isn’t leaving the money to his children and grandchildren. Were you to ask me, I’d probably draw the line at a couple million dollars, saying that if you want to follow an indexing strategy and had at least the low seven figures invested outside of the confines of such protection in the pooled, public index fund rather than your own privately constructed index fund, you may mean well but you’re behaving very foolishly.

I wish I could say it more kindly or in a way that doesn’t risk offending you, and no matter how much you may dislike me for bringing it to your attention, it doesn’t change the fact that with a tiny bit of effort, and knvesting no additional net expense, you could eliminate the possibility of triggering embedded taxes, enjoy tax lost harvesting, and likely higher long-term returns due to the superior methodology of initially equal-weight positions entirely and yet you choose not to out of a misunderstanding of what it is you own, the way it is structured, or obdurance.

The opportunity cost of the lost wealth is real. It is meaningful. You and your heirs have no one else to blame. There isn’t even a major convenience advantage, anymore; not at that size. If you’ve ever worked with a private asset management firm, you know that getter can log in to your custody account as easily as better investing index can an account holding a public indes fund. There’s no real downside here provided, again, the requisite scale is present.

Nevertheless, whenever I mention this, there will inevitably be hate mail that flows into my inbox. It’s unavoidable. They don’t realize how significant the advantages of indexing directly in a private account can be overusing the pooled public structure once you’re rich. As a result, they refuse to even look into it, in which case it becomes abundantly clear that there’s no real cause for disagreement. The facts are the facts. It’s not a matter of taste like chicken versus beef, it’s a matter of numbers.

One particularly large drawback of most index funds is that they are not intelligently representative of different sectors and industries. Something like an individually managed account might be able to sidestep that; creating a private index fund like I’ve already discussed and then weighting certain sectors and industries more heavily in favor of underlying fundamentals.

Alternatively, if you are a do-it-yourself investor, you could hold a core collection of index funds then tilt the portfolio in certain directions through the introduction of individual stocks designed to increase their weighting relative to the index. My suggestion would be to start by considering the industries that have historically produced higher than average long-term returns. There is a reason they produce higher-than-average returns on capital.

Yet another invssting of index fund investing is the societal consequences.

Investing in the S&P 500

Why are index funds so popular?

Solactive bettef the index, which began on April 9,at a base jnvesting of To see the top companies held by BetterInvesting better investing index, go to the Betger website at www. Toggle navigation. For more information, visit www. Toggle navigation. Store Help Center. BetterInvesting’s individual members and investment clubs tend to have a longer-term focus than do institutions, with clubs’ average holding period for stocks at 3. BIXX’s total return index ended March at Store Help Center. BetterInvesting’s individual members and investment clubs tend to have a longer-term focus than do institutions, with clubs’ average holding period for stocks at 3. BIXX reflects actual portfolio decisions by individual investors in investment clubs, while other indexes are weighted heavily toward decisions by large institutional investors.