Index funds are great tools to diversify your portfolio; their low cost structure gives you, the investor, a great deal more for your money.  With everyone including Warren Buffett praising index funds what could possibly be wrong with them?

The problem is that index funds are stupid, they go for a ride where ever the market goes completely ignoring the fact that hysteria happens and people dump stocks on bad news or buy it on good news. Balancing out a portfolio based on market value of a security within the index means that it’ll be naturally underweight precisely at the time when you should be buying and overweight when it’s a good time to sell.

That could easily be avoided by getting a value adjusted index fund. In this type of fund the weight of a stock in the index is influenced by some rudimentary statistics like book value or the price-earnings ratio.  Stocks with a good value would get a slightly higher weighting than the market value would suggest.  Similarly stocks that are not looking good from a value perspective will be bought less than its weight in the index. The value adjusted index fund seems like a great investment. But the selection just isn’t there.

There are ETFs for just about everything, almost none of them do anything intelligent to reduce the risk during a recession or bubble.  They are the perfect investment vehicle for long term investing because over the long term returns should be pretty good.  In the short term however there is no risk management.  A good investment manager at least has a chance to do things like avoid overly volatile stocks, or highly speculative stocks.

There is an interesting dynamic that can happen in the event of a major market shift.  Money managers with their head to the ground can make quick decisions that move the market.  About a week later there can be an echo effect where all the people at home, have read the newspaper, done their research, came to a decision, and called their broker to move all their money in reaction to the market. That echo can move the market further in the same direction.  An ETF plays it neutral, buying/selling in sync with the market whereas the quick buying money manager will see additional gains as a result of the second market movement.

There is some very good research being done that shows simple analysis can decrease risk and increase returns.  Academic studies that examine various trading strategies over the long term find better performing algorithms than index funds.  Why ignore that research and just buy everything?   Why expose yourself to risk that can be managed?

I don’t want to say that index funds and ETFs are bad investments.  They are probably one of the best investment products available, however, they are not perfect, and you should be aware of the risks.

Technorati Tags: etfs, index funds, investing, risk management

This entry was posted on Thursday, March 6th, 2008 at 1:26 pm and is filed under Stocks. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.