Index funds are seen as low-risk investments, but the reality is there’s still some short-term and long-term risk with them. Losses are possible and you have no protection against them. You should understand a few of the disadvantages of investing in index funds before moving forward.
- Index Funds Can Under Perform
One of the main disadvantages is that an index fund can under perform and it’s actually very common. This occurs when the fund does not perform as well as the larger index that is being tracked. This means your money is not growing as quickly as it would by being placed into other funds. The under performance could go on for several years and lead to a significant amount of lost growth. A fund that consistently under performs can throw off financial plans if it doesn't keep pace with the rest of the broader market.
- No Active Management of the Fund
An index fund doesn’t have active management. Active management means a financial professional rebalances or adjusts investment portfolios in order to get better performance. This is not how index funds work. The fund is only managed when the index being tracked adds or removes a stock or investment. This means that you are basically at the mercy of the market or main index. If the market is going through a downturn or a volatile period, then the index fund is likely to match that performance. The results are potential losses even when they could have been avoided with active management.
- No Potential for Exceptional Growth
Index funds are a very specific type of investment. They are meant to match the performance of a larger financial index, but they are not designed to exceed the performance of that index. This is a disadvantage because there is no potential for exceptional growth beyond the markets and the tracked index. Your investments can suffer because the fund is not taking advantage of any other options. You might have to live with average growth with little to no chance of ever outperforming the tracked index.
- No Flexibility or Individual Control
You have no flexibility and no individual control over the underlying investments in an index fund. Investing in an index fund is an all-or-nothing proposition. You cannot choose to exclude or include different stocks. You cannot invest more in one part of the fund than in another part. You are investing in the entire fund as it sits. This lack of flexibility can become frustrating if you think you could do better by tweaking some investment options. Unfortunately, index funds have strict rules for investing and investors, therefore you can’t customize it.
- Some Index Funds Can Be Over-Focused
A final disadvantage is that some index funds might be over-focused. This means the fund is focused on a financial index that tracks only one small niche or part of the market. These funds lack diversity and the problems within one sector can cause serious losses for the fund. An over-focused fund can be disastrous if an industry, government, or other entity making up the index collapses.