“What are the hidden risks of index investing?” Few seem to be asking that question nowadays.
Perhaps that’s because there’s a war going on in the asset management business: a scramble to slash fees and attract the hundreds of billions of dollars pouring into passively managed investment vehicles like exchange-traded funds and index funds.
In the first seven months of 2018 alone, U.S. ETFs saw inflows of $148 billion. In August, Fidelity went so far as to launch two zero-fee index funds.
Obviously, this competition is great for investors. But even free index funds and dirt-cheap ETFs can have downsides lurking beneath the surface. Here’s a gander at some of the hidden costs and risks of index investing.
[See: 7 Stocks That Soar in a Recession.]
Index funds buy high and sell low. This is the inverse of how successful investors do things, of course. But from time to time, index funds are forced to do exactly this.
“When an index changes constituency, if it is scheduled and expected … it always promotes arbitrageurs to buy expected index-in stocks and sell (short) index-out stocks,” says K C Ma, professor of finance at Stetson University.
It’s not unusual for stocks to be booted from a certain index, particularly if the business is struggling and the stock price is in secular decline. These are replaced with different stocks with more promising futures, and both decisions are made by a body of the index overseers.
“In 2014, 15 companies were removed from the S&P 500 as they were replaced by new entrants to the list,” says Robert Johnson, principal at the Fed Policy Investment Research Group. “In prior years, 23 companies were removed in 2011 and 18 each were removed in 2012 and 2013,” Johnson says.
Since these decisions are almost always publicly announced at least several trading days ahead of the actual change themselves, traders benefit by buying the new members and selling the exiles, while funds tracking the index have to wait until the actual changes are made.
Increased governance risk. This is a particularly interesting risk to index investing, because it’s an opaque area.
“Because index funds are required to passively invest in every stock in the index, there is little incentive to be actively involved in individual company governance issues,” Ma says.
This in and of itself can be a good or a bad thing, but in one area in particular, it can prove costly: compensation packages.
Index funds use their significant proxy voting powers to approve of executive pay packages 19 percent more often than active funds do. C-suite executives of publicly traded companies are notorious for handsome compensation plans, often heavily skewed toward stock-based compensation that requires the issuance of new shares, diluting existing shareholders.
Other corporate governance risks could also materialize and worsen as passive investing grows in popularity. Can one expect the ETFs and index funds tracking the Russell 2000, for example, to know which way to intelligently vote their shares on various issues in 2,000 different companies?
If index funds almost always blindly vote the way management recommends, bad actors will find a way to take advantage.
[See: The 10 Best ETFs to Buy for 2018.]
Tracking error. Investors should always check this metric when they’re buying an ETF or index fund. Remember, you’re not buying the index itself, you’re buying a product that tracks it.
The “R-squared” metric measures how closely this tracking is, ranging from 0.01 (1 percent) to 1 (100 percent). The closer to 1, a perfect correlation in returns between index and tracker, the better.
Uncertain performance in extreme conditions. ETFs in particular have shown a vulnerability in times of abnormally high volatility.
“When there is market pressure, the price of the ETF may not reflect the price of the index, and it may trade at a huge discount and loss of value,” says Vijay Vaidyanathan, chief executive officer at Optimal Asset Management.
This happened in both the flash crash of 2010 and on Aug. 24, 2015, when the S&P 500 cratered 5.3 percent within minutes of the opening bell and ETFs from every major fund family went haywire, losing between 20 and 50 percent.
Obscurity risk. As of 2018, it’s quite unlikely that, for example, a company like Vanguard will stop offering its ETF tracking the S&P 500 index, VOO, any time soon. But not all fund families have over $5 trillion in assets under management, and not every ETF tracks the S&P 500.
More obscure funds tracking lesser known indices can present problems.
“For less popular indices, there is a significant risk of the provider discontinuing the ETF, in which case you can get liquidated without your consent, or worse, the ETF provider doesn’t discontinue it, and you’re left with an illiquid ‘zombie ETF’. In that case, when you sell, it will likely be at a discount,” Vaidyanathan says.
Purchase and redemption fees. Obviously, most passive funds aren’t yet adopting the Fidelity zero-fee model. The fees you know you’ll pay are clearly revealed in the expense ratio. But some funds, even if they’re “no-load” funds, can sneakily charge purchase and redemption fees, so read the fine print to look for those sorts of hidden fees.
One Final Note About Index Investing
By simply perusing the above list, you might get the idea that ETFs and index funds are horribly flawed investments, poorly designed and doomed to fail whoever buys them.
That’s not true.
But it’s always important to know the risks involved when you’re investing, and investors equipped with the above information will be able to make more fully informed decisions.
That said, buying and holding a low-cost index fund that reliably tracks a major U.S. stock market index like the S&P 500 is, for many investors, the best investment in the stock market they can make.
Why? Because across the board, and over long periods of time, time and time again, people who try to “play the market” themselves dramatically underperform the indexes — and so too do actively-managed funds.
Over the last 20 years, the S&P 500 has returned 7.2 percent annually, while the average investor has returned just 2.6 percent annually, barely keeping up with inflation.
[See: 7 of the Best Stocks to Buy for 2018.]
It’s OK to look a gift horse in the mouth. Just remember to keep it when you’re done.
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6 Hidden Risks of Index Investing originally appeared on usnews.com
