Millions of investors have adopted a simple philosophy: If you can't beat 'em, join 'em. That's the basic principle behind passive index investing, in which you try merely to match the overall performance of an index rather than seeking to outperform it. Given how many active stock mutual funds fail to match the performance of their respective stock market benchmarks, that philosophy has worked well for stock investors.
But one key you need to understand about index investing is that it's only as good as the index you follow. In many markets, index investing creates problems that actually cost passive investors in lost returns.
When friction kills
A lot of attention about the downsides of index investing have focused on stocks and the ability to take advantage of massive index funds that are required to buy or sell particular stocks when they get added or deleted from the indexes they track. For instance, many point to the run-up in Facebook (Nasdaq: FB ) shares between early June and the June 22 date on which the social-media stock joined the Russell 1000 as having been motivated at least in part by index-tracking funds.
But the problem goes beyond large-cap stocks. Other investments have also had mixed success with the passive approach.
Take, for instance, the U.S. Natural Gas Fund (NYSE: UNG ) . Following a formulaic approach toward trading natural gas futures to give the fund exposure to changing gas prices, the ETF has suffered huge losses as natural gas has been in a massive bear market in recent years. Yet although falling gas prices and the ever-present unfavorable trends in the futures market have definitely combined to produce bad performance for the ETF, another problem is the predictability of its moves. Smart natural gas traders are able to anticipate the ETF's moves and profit from them, while the ETF has no choice but to follow its rulebook.
Not all commodity ETFs have that problem, though. With SPDR Gold (NYSE: GLD ) and iShares Silver (NYSE: SLV ) , for example, the passive approach works well: The ETFs merely buy the appropriate amount of bullion, and then sit and let commodity prices move where they will. Over time, the expense of storing all that bullion eats slowly into the intrinsic value of ETF shares, but that friction is relatively small compared to what you'd pay a coin dealer to buy and sell actual physical bullion.
The trouble with bonds
Passive investing with bonds can get even trickier. As an article in this weekend's Barron's noted, many of the bonds that bond ETFs have to buy and sell don't have enough liquidity to handle the volumes involved when crisis situations arise. The result is that ETF shares can trade at premiums or discounts to their actual value, costing those who buy or sell at the wrong time. In particular, high-yield bond funds SPDR Barclays High Yield (NYSE: JNK ) and iShares iBoxx High-Yield Corporate have seen disruptive volatility, especially given investors' hunger for higher-yielding income investments.
High-yield bonds aren't the only area that's open to such danger. If tax increases take hold next year, then any increase in popularity of municipal bonds could trigger a similar phenomenon. Foreign bonds also have the same bottleneck potential, as most foreign bond markets have nowhere near the liquidity that Treasuries have.
Where stocks fear to trade
Once you get past the top companies in the market, many stocks are very illiquid. Tiny micro-cap stocks have so little interest that even a small institutional trader can greatly disrupt their trading. High spreads between bid and ask prices and thin trading raise transaction costs, making index funds that specialize in micro caps far less efficient than their large-cap counterparts.
As foreign stocks have gotten more popular, they also raise concerns. Big international markets are largely as efficient as U.S. markets, but some of the smaller emerging markets have struggled to handle the onslaught of investor interest in their listed companies.
The right strategy for the right stocks
Index investing is a great way to produce fine long-term results, but it isn't a panacea. Before you commit to a purely passive strategy, make sure you understand the downsides of indexing and take steps to protect yourself from its biggest failings.
One answer is to add some individual stocks to your index-fund portfolio. For some good prospects, you may want to consider U.S. companies that have achieved a big presence not just domestically but throughout the global economy. Learn the names of three of the best in our latest special report: "3 American Companies Set to Dominate the World." This report is completely free, so don't miss out!