Index funds can provide low-cost exposure to market segments, but they also lock investors into those segments, as Kyle Tetting explains in a Money Talk Video.

Joel Dresang: Kyle, in 2014, two-thirds of investor funds flowed to indexes. Let’s talk about that. And first of all, what’s an index?

Kyle Tetting: An index is a basket of stocks. It represents something larger, such as a sector, a region, a country. And so what you get is a very broad way, a diverse way to invest in whatever that underlying representative piece is.

Joel: So how do you invest in an index?

Kyle: Well, you have to find someone that tracks that index. There are a lot of fund companies and ETF makers out there that build product to track the indexes. And so ultimately, what you’re doing is buying something from someone else that tracks the index you want to buy.

Joel: What’s the attraction?

Kyle: It’s low-cost. So you can get that broad diversification we talked about. And again, it’s not any more just the S&P 500 or the Nasdaq or the Dow but really a whole host of different index alternatives that are out there. And you can get those indexes at a very low cost relative to many other investment opportunities or trying to build it yourself, trying to go out and buy all the securities in the index yourself.

Joel: And the cost is lower because it’s passive management. You’re just following those stocks in that basket, and it’s trying to capture what that basket is doing.

Kyle: Yeah, it is. A lot of those indexes are rules-based in the way they’re constructed, and so what you get is a basket of stocks that’s not going to change very frequently, maybe once a year. And those changes are going to be pretty small when they do occur. You don’t get a lot of looking through the portfolio to see, okay, what might be going wrong here? And that can certainly lead to some problems.

Joel: What are some other drawbacks?

Kyle: Well, I think the biggest issue you get is that while you’re tracking that index, you’re taking index risk. But when you add the expense of that index, you’re never going to get the return. You’re always going to get a little bit less.

The other big thing that we’re seeing is that as, particularly right now, large-cap stocks have been quite in favor, things like the S&P 500 have looked great because it represents that big area in the U.S. market.

But when we see other areas of the market start to rally relative to the large-cap stocks, it may not look so good anymore. And so an active manager, for example, that has a little bit larger opportunity set, may have the opportunity to capture some of those things that the S&P can’t.

Joel: So those indexes lock you into those stocks that are in that index.

Kyle: That’s absolutely right, Joel. You are very much captive to the rules of the index. And I would say that’s not necessarily true for a lot of the other investments that we’re looking at or that a lot of investors out there are looking at.

Joel: So to know a little bit more about what’s in the index and how that’s going to fare as the markets change?

Kyle: Absolutely.  I think that’s key, is understanding what it is you have. And that doesn’t go just for the international indexes, but it goes for all the indexes that you could potentially buy.

Joel: But these still play a role in most people’s portfolios?

Kyle: I think there’s a very important role for low-cost participation in markets. We don’t see it as one or the other, active or passive. We see it as kind of a complement to each other.

If I can get broad exposure to U.S. stocks with the S&P 500 index, I’m going to take it if I can get it for a low cost. But at the same time, I like the idea that there are active managers out there who can manage the risk side of the portfolio for me, who can kind of keep an eye on things and make sure that they’re taking advantage of opportunities that might not be available in the S&P 500.

Kyle Tetting is director of research at Landaas & Company.

Joel Dresang is vice president- communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted April 10, 2015)

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