ByJustin Pritchard, CFP®
Index funds are popular investments—and for good reason. But there’s some confusion about what index funds do and the level of risk you take when using these investments.
A primary benefit of index funds is their low cost. But when it comes to safety, index funds can be risky, safe, or anywhere in between. The particular index fund you choose determines how risky it is, and index funds are not substantially safer (or riskier) than actively managed funds.
On this page:
- Selected advantages of index funds
- Some risks related to index funds
Benefits of Index Funds
Low cost: Investors in index funds typically pay lower fees than investors in actively managed funds. You don’t have a manager (or a management team) deciding which underlying investments to buy and which ones to avoid. As a result, you might reduce the costs for compensation, research, travel, and more.
Passive investments: One reason for low annual operating expenses is that index funds are passive investments. An index fund is designed to behave just like “the market,” or a basket of investments that have been grouped together. Those investments typically share a common characteristic. For example, they might all be companies with a large market share in the United States, which could describe the S&P 500 Index.
Low turnover: The tax costs of owning index funds can also be low. Because these instruments tend to have low turnover (they usually don’t buy and sell as frequently as active funds), you might be less likely to take capital gains. That’s especially important when it comes to short-term capital gains.
Tracking the market: An index fund tends to track the underlying index (or “the stock market,” in some cases, depending on how you define the market). For better or worse, your returns are usually very close to the market you’re tracking with an index fund.
- On the bright side, you don’t need to worry about mutual fund managers making bad picks or missing out on opportunities.
- However, it’s highly unlikely that you’ll outperform the market when you use an instrument that’s designed to simply mirror the market.
Safety in Index Funds?
Perhaps because of their popularity, index funds are sometimes perceived to be the safest way to invest. The benefits above are not to be ignored, but index funds are not necessarily safe investments. Put another way, they’re not substantially safer or riskier than any other type of mutual fund.
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Index funds invest in whatever their underlying index is composed of. A few of the most common indices used in index funds include:
- S&P 500: Large U.S. companies (people often refer to this as “the stock market”)
- MSCI EAFE: Companies located in developed nations of Europe, Australasia, and the Far East
- Wilshire 5000: Tracks the movements of almost all stocks traded in the United States, although there aren’t necessarily 5,000 investments included
- Barclays Capital Aggregate Bond Index: Investment grade bonds traded in the United States
Many other indices (or indexes, if you prefer) exist.
Index funds can invest heavily in stocks, and almost any investment in stocks is risky. Stocks, also known as equities, are generally considered risky by definition.
Example: In 2008, the S&P 500 lost roughly 38%, and it was down more than that before recovering some of the losses. Every S&P 500 index fund was likely down just about as much (any minor difference would be due to tracking error and dividend payments).
If you examine any S&P 500 index fund, you’ll see that it more or less matched those returns. Plus, you can see that the category average for Large Blend funds in 2008 was negative 37.79%.
Granted, 2008 is extreme, but index funds will participate in any market downturn, whether large or small. They also participate when markets are strong.
What About Bond Index Funds? Safe?
Even “safe” investments like bond index funds can lose money. As just one example, investments tracking the Barclays Aggregate Bond Index were down at least 2% in 2013 (and more than that, at the lowest point in the year). That’s not a huge loss, but it might be surprising if you think that bonds + index funds = safe investing.
The reason for bond market losses in 2013 was a rise in interest rates, but bonds can lose value for other reasons. For example, high-yield bonds (also known as “junk bonds”) pay relatively high interest rates because there’s a higher chance that you’ll lose your money. Those higher-risk bonds are exactly what you’ll find inside of high-yield bond index funds.
Compared to What?
Given the statements above, you might be tempted to believe that index funds are unsafe. But they’re not any more unsafe than actively managed investments. You can confidently assume that plenty of actively managed U.S. stock funds lost 38% in 2008 (give or take a few percent or more, depending on the fund’s objective). Likewise, some actively managed bond funds lost money in the Fall of 2013.
The point isn’t to compare active and passive strategies, but rather to make sure you understand that index funds aren’t necessarily safe investments. You can lose money if investments in the index lose value. Since many of those indices are financial markets, you should expect them to go down from time to time.
Managing Risk
If you want to keep your money safe, you’ll probably have to accept some tradeoffs. The safest place for money is, of course, in a government guaranteed bank or credit union account (assuming all of your money is insured by the FDIC or NCUSIF). But if you want to pursue potential growth using index funds, you face the classic investment decisions:
- How much to invest in stocks, bonds, and cash
- How much to invest in U.S., developed, and emerging markets
- What types of bonds to invest in (government, foreign, corporate, or junk? Short-term, floating rate, or longer-term?)
- What types of stocks to invest in (large, small, U.S., foreign, emerging market, etc.)
- Any other types of investments you want exposure to (assuming you want to use index funds, and that index funds are available in those categories)
Unfortunately, managing your risk is a complicated matter and demands more thought than just buying an S&P 500 index fund or some Aggregate Bond Index. There are index funds that invest in a broad variety of investments, and doing some research might help you build a diversified portfolio that’s appropriate for your circ*mstances.
Which Index Funds are Safest?
So you still want to know what to pick? By now, you realize there’s no simple answer, and it depends on what you mean by “safe.” There is always a tradeoff: Picking one kind of safety means taking a different type of risk. Assuming you want to take more risk than a bank account:
- If you want to minimize market risk and default risk, consider “conservative” or high-quality bond index funds.
- If you want to avoid losing money in bonds when interest rates rise, look at shorter-term bond funds (and favor high-quality to reduce “credit” risk).
- If you want to avoid losing purchasing power over several decades due to inflation (“going broke slowly”), use diversified stock funds or asset allocation funds—but now you’re back to taking market risk.
When most people search for the safest index funds, they’re probably looking for short-term, high-quality bond funds. Those are less likely to suffer significant losses during market events. But they might not keep you safe from inflation or offer significant long-term growth.
The Devil in the Details
We can start with an oversimplified statement: When it comes to market volatility, index funds are not substantially more or less risky than actively managed funds.
But you know it’s more complicated than that. Most people don’t care about those details, but a few complications that come to mind are:
- An actively managed fund might be more concentrated than an index fund, and losses in one of its holdings could make it more volatile (when we talk about volatility, we’re really just talking about the losses and ignoring the gains—that’s what most people do).
- At the same time, the largest companies can skew cap-weighted index funds, so activity in a few popular stocks might make index funds perform differently than a well-diversified active fund.
- Depending on what you want to call “risk,” you risk paying more short-term capital gains and trading expenses in an active fund.
- Depending on what types of funds you want to allow into any comparison and what time frames you choose to look at, active funds with hedging operations (currency or basic options, for example) might do better or worse than passive funds.
Some Disclaimers:
One cannot invest directly in an index. Index is unmanaged and index performance does not reflect deduction of fees, expenses, or taxes. Presentation of Index data does not reflect a belief that any stock index constitutes an investment alternative to any equity strategy or is necessarily comparable to such strategies.
Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time and issuers may reduce dividends paid on securities in the event of a recession or adverse event affecting a specific industry or issuer.
None of the stock information, data, and company information presented herein constitutes a recommendation or a solicitation to buy or sell any securities. Any specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and you should not assume that investments in the securities identified and discussed were, or will, or will not be profitable.
