Are Index Funds Less Risky Than Active Funds?

Index funds are not immune to risk.

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There seems to be a common belief that using an index fund or a passively managed exchange-traded fund (ETF) reduces risk.

In terms of investment risk, that is a misconception. An index fund takes on the risk of the underlying index it tries to replicate. For instance, in 2008 the S&P 500 Index lost 37 percent. There are many funds and ETFs that track that index. They all lost around 37 percent plus the fund's expenses. For example, the Vanguard 500 Index Fund (symbol VFINX) posted a loss of 37 percent for the year.

[See PIMCO'S Bill Gross Wades into Active ETFs.]

On the flip side, index funds can eliminate manager risk, or the risk of investing in an actively managed fund only to see the manager underperform the benchmark index. Here are instances where index funds have outperformed the majority of active managers:

  • The Vanguard 500 Index Fund outperformed 62 percent of the funds in Morningstar's large blend category for the five years ending March 31, 2011.
  • Over the same time period, the Vanguard Small Cap Index Fund (NAESX) outperformed 73 percent of its peers.
  • Likewise, the Vanguard Total Bond Market Index Fund (VBMFX) outperformed 57 percent of its peers over this five-year period.
  • This is not to say this will be the case with all index funds over all periods of time. However, a well-run index fund should track its underlying index closely and deliver index-like performance.

    [See Why The Federal Reserve Isn't Worried About Inflation.]

    Several years ago an instructor at a continuing education session said that many of the actively managed mutual funds atop the 10-year rankings in their respective categories most likely spent three of those calendar years in the bottom quartile of their category rankings. For an investor who held one of these funds over that entire 10-year period this isn't a problem. But investors who bought into such a fund at a different time or over various periods of time may have had quite a different experience.

    A few points about index funds:

    Expenses matter. You should generally buy the cheapest index fund that tracks the index you are interested in. There is a huge disparity in the fees for funds that track the S&P 500 for example.

    Understand the underlying index. There has been a proliferation of new index ETFs tracking a variety of indexes. In many cases I have never heard of many of these indexes. Make sure the index tracked by the fund you are considering makes sense for your overall portfolio.

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    Using index funds is no guarantee of investment success. Just like with any mutual fund or ETF, how you use these products is the key to your success. Index funds are nothing more than a building block to construct your portfolio.

    Don't dismiss active managers. Evaluate actively managed funds and understand how they have been successful in the past and in what types of environments they might lag their peers. Moreover, carefully think through the role the fund might play in your portfolio, and be aware of who is managing the fund. Is the same person or team that actually compiled the impressive track record still in charge? Or has this manager moved on, placing the fund in the hands of some new, unproven manager?

    There is no definite answer as to whether one should use an index fund or an actively managed fund. The answer depends on the fund and what you are trying to achieve with that portion of your portfolio.

    Roger Wohlner , CFP® is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill. where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn.

    Clarified on 4/27/2011: This story has been clarified to indicate that author is referring to passively managed exchange-traded funds.