Things you need to know about index funds and ETF investing

Index funds and ETFs investing literally exploded in the last decade. They have become a major force in the investing world. Passive investing through index funds offers a simple and cost-effective way to gain various types of exposure on financial markets, offering both to retail and institutional investors new ways for building a portfolio.

Although they growing popularity, there are many things that often gets overlooked and that you should definitely consider before putting in place your investing strategy, especially if you are in for the long-term.

In this article, we are going to present some data on index investing, analyze how diversification is put in place and why it might not be a good thing, the capital allocation in index funds and discuss their returns compared to market returns, considering also the implications for a long-term investing strategy.

Let’s start!

Growth in Index Funds and ETFs

Index funds and ETFs are financial securities with a portfolio that basically tracks the performance of a well defined set of assets, like the components of a market index or other particular assets.

They are traded as a single stock and provide a market exposure with low operating expenses compared to actively managed funds and oftentimes with a low portfolio turnover.

Those characteristics made them really popular in the last few years, in fact the ETF sector is exploding with growth expected to reach $7 trillion by 2021, and new flows into this sector have helped to propel the boom in passive investing.

Overall we saw noteworthy capital flows into passively managed funds over actively managed funds:

etf-index-funds-capital-flows
Chart by visualcapitalist.com

Consequently, marked demand and large adoption resulted into a big growth of the ETFs  assets under management as you can see from this chart:

etf-growth
Source: statista.com

One thing is sure: index funds investing is becoming one of the major resources for a growing number of investors and ETFs accounts for larger portions of the markets.
There is so much selection that you can implement pretty much every strategy that you want.

While there are some clear advantages when it comes to passive investing, like low fees, ease of access and liquidity, the advice to “invest in index funds and you are ok” that many suggest should be questioned a little bit more.

Indeed, blindly invest in index funds is a strategy that may actually result in lower returns compared to the market.

ETFs diversification: good or bad?

By definition, index funds are investments that have a certain degree of diversification. They all invest in a certain number of stocks and their return is proportional to their underlying assets.

Diversification is a mantra of investing, and of course there are very good reasons to be diversified.
The thing is that in some cases diversification can be a disadvantage and that might be the case with many index funds since the assets allocation is based on the composition of the index.

Suppose that you bought Apple in the 90s when it wasn’t the Apple that we know today and it was really cheap. Now your return would be great, but if you bought an index fund that contained Apple among many other stocks, you would have had a lower return compared to single investment in the company.

When you invest in many stocks you are protected against the failure of a single company because there are many other that do well in the index but this prevents you from achieving great returns that you may have by picking the right stock.

If you think of a great investor like Warren Buffett, he made its fortune by carefully selecting a restricted number of companies, if he went out to invest in 1000+ stock we wouldn’t even know his name. The astonishing performance of the legendary investor was achieved through a super concentrated portfolio.

Capital Allocation in Index Funds and ETFs

When you buy an index fund, it is really unlikely that you are invested in a very small number of stocks.

The focus of people on lower costs, ease to access, high diversification and investing strategies made possible by ETFs made them very popular among all kind of investors.
However, as we started to see in the previous part of the article, there are also clear disadvantages of index funds investing that, especially for long-term investors, are worth thinking about.

With index investing you take in good companies and bad companies without any distinction, and since your allocation is based on the index you end up investing more on the most expensive stocks because they make for a larger portion of the index and less in the smaller stocks, those that might be even better than the hot stocks and oftentimes lead to higher long-term returns.

At the end of the day, unless you are doing short term trading, what determines your return over the years is the business.

With index funds you have a very broad diversification that implies a bad capital allocation because indexes are market capitalization weighted, the stocks with a higher market capitalization accounts for a larger portion of the index: the larger the stock, the more of the index fund will be invested in that company.

They invest as the market is, the percentage of a stock in the index depends on its capitalization, this inevitably brings you to invest a large portion of your capital in the hot stocks.
This is a serious concern if you are investing for the long-term because in doing so your are limiting your potential returns.

For example, if you invest into an index fund that tracks the S&P 500, you are basically investing in corporate America with an average earning yield of 5% and a P/E ratio of 20 or even more.
In addition, most of your capital will be allocated in the most expensive stocks. In the case of S&P 500, 4.21% goes to Apple, 3.57% goes to Microsoft and 3.34 to Amazon.

What you are doing is buying more of the cool stocks and less of the stocks that might be undervalued, making the large cap stocks even more expensive. In a certain measure, the markets are also distorted by the massive capital flows in index funds and ETFs.

If you are in for the long-term, you can do much better by taking a look at smaller companies and selecting value stocks. Also, you should think twice before starting a dollar cost averaging strategy of ETFs because of the way that they invest your money, that is mostly in already expensive stocks with lower long-term return potential.

Index funds and market returns

In addition, one of the final and most important point is that due to broad diversification you are not going to outperform the market.

That is by definition one of the major drawbacks of index investing, since they are designed to track the market they can only do as well as the market does. Oftentimes you also get some kind of tracking error due to rebalancing of the funds.
Historically the market has always risen over the long-term but don’t expect to be a winner by investing through index funds.

That doesn’t mean that if you start picking stocks you are going to beat the market, the truth may be the opposite, but if you do it the right way, you have a chance to achieve this goal.

On the other hand, index funds allow you to gain exposure to different asset classes in an easy and accessible way, and although they can’t beat the market, remember that neither actively managed funds do that!

Conclusion

To sum up, index funds and ETFs are cool because you can easily invest in many asset classes and sectors with financial instruments that represents a portfolio and is traded on the market like a single stock.

The low fees associated with passive investing, together with a growing demand for all kind of investors, made them very popular and today we can see huge capital flows toward this kind of investments.

Here is a (very short) list of what are the main advantages and disadvantages of index funds investing and ETFs.

Advantages of index funds and ETFs

  • Easy to gain exposure on many different sectors
  • Low operating expense
  • High diversification
  • Traded on the market as a single stocks
  • Choice among numerous funds

Drawbacks of index funds and ETFs

  • Lower returns compared to the market
  • Potential tracking error
  • Incidence of fees
  • Bad capital allocation and suboptimal diversification
  • Not the best choice for a long-term dollar cost averaging strategy

What to do?

In the end, it all depends on what are your investing goals.
Although index funds and ETFs are very popular and saw a large adoption, you should not rely entirely on index funds and ETFs because of their limits and their structure.

First, the capital allocation that is market capitalization based leads to invest more in the larger and most expensive stocks, limiting your ability to invest in smaller stocks that might have higher growth potential.

Secondly, you can’t expect to beat the market by investing as the market. You can be exposed to market movements, that are generally up over time, while being protected from a single company going broke but you can’t achieve extraordinary returns

The truth is that not even actively managed funds beat the market, the majority of them actually underperform, so if you are looking for a way to track a particular sector ETFs might be the right option, but if your plan is to achieve long-term returns through a dollar cost averaging strategy you can do much better by looking at the business fundamentals and focus your portfolio on a small number of great companies.


This article is for informational purposes only, it should not be considered financial advice.
You can read the full disclaimer here.

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