How Index Funds Can Lead to Worse Investor Performance

A few months ago I wrote how lower investment costs hurt investors. In this post I talk about how the perception of index funds may lead investors to make decisions that could worsen their (already poor) performance.

The Growth of Index Funds

Over the past few years there has been a significant change in investor preference. Since 2012, there has been a substantial shift to passive index funds, away from actively managed funds. Cost is often the main factor attributed to the change. But index funds have been around for decades…so why the big shift now?

Another factor is performance. Lots of studies show that actively managed funds, after their fees, are not able to keep track with index funds. True. So in that case they are simply chasing performance now…which is par for the course for most investors. I find it interesting that the big ramp up in index funds has occurred during a bull market with relatively low volatility. Investors haven’t had to think much about risk.

Risk? What Risk?

The recent herding into index funds has occurred without a significant market event. These investors have yet to be tested. We can hope that index investors will somehow be unaffected by losses – I don’t think so. It’s not as if losses only matter when owning an actively managed fund. And let’s remember, every study published on investor behavior has demonstrated a significant gap between how the index/fund performed compared with how the investor in that index/fund performed.

How Index Funds Could Make Losses Worse

There is no risk management in passive index funds. We all get that. You get 100% of the upside and downside of the market it represents. So what happens when the market goes down 10%, then 15%, then 20%? Analysts will be slashing estimates, companies will be laying off and we may have a recession on our hand. We know it will happen at some point because its part of the market cycle – that’s not a question. The question is how we will respond.

Because there is no risk management in index funds, investors may feel the need to do it themselves. “I can’t have another 2008/2009…there is no one to protect me…I better sell.” Whereas, an investor in a managed fund may be psychologically able to hold on longer, if only because of the perception of risk management. An active fund has the potential to offer some risk management. Sure they could use that potential to make very costly decisions, but the perception that the manager knows what he/she is doing may help the investor stick with it through the downturn.

Agnostic to Investment Vehicle

I am agnostic to whether an investor uses an index fund or managed fund. In some cases and for some investors each type, or some combination may be appropriate. The greater focus ought to be on what the heck you are going to do when losses accrue and the future looks bleak. Having a written “pre-committment” plan can be very helpful; intentions often don’t cut it when it comes to investing. And owning a passive index fund isn’t going to change your behavior.