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Index funds have given many small investors a great solution for getting exposure to the stock market. Yet they're far from perfect. Sometimes, index funds do some pretty nutty things. But it's not really their fault -- because they're only following in the footsteps of whatever indexes they track.
Why an index fund?
Whether you invest in funds or individual stocks, you probably compare your performance to that of a common stock benchmark. Many investors use the S&P 500 index, which includes 500 of the largest U.S. stocks, as a guide to figure out if they're beating or trailing the broad market's return. The S&P 500 is so popular as a benchmark that it was the tracking index for the first index fund available to individual investors more than 35 years ago.
Index funds responded to the concept that active management increases costs while failing to improve returns in any predictable way. Although some exceptional managers beat the market indexes regularly, there's still a lot of debate about whether those results are because of skill or just luck. Those who believe the latter wanted a cheap, efficient way to match the market's average return, and index funds gave them exactly what they wanted.
Is Standard & Poor's smart?
But it's important to understand that when you buy an index like the S&P 500, you aren't investing in a completely passive way. Standard & Poor's, which manages the S&P 500, makes changes to its benchmark index from time to time -- and some of those changes have turned out to reflect some really bad timing.
For instance, consider these ill-timed moves:
- In 2000, the S&P 500 replaced many old-economy stocks with up-and-coming tech names Broadcom (Nasdaq: BRCM ) and JDS Uniphase (Nasdaq: JDSU ) , among many others. It also added utility Dynegy (NYSE: DYN ) in the wake of the deregulatory fervor that eventually led to Enron's demise.
- More recently, after kicking Ingersoll Rand (NYSE: IR ) out of the S&P 500 in early 2009 in favor of Quanta Services (NYSE: PWR ) , S&P returned it to the index in November. During the time it was out of the index, Ingersoll Rand's stock almost doubled, while Quanta lost nearly a quarter of its value.
When you think about it, it makes sense that the S&P 500 would typically involve buying high and selling low. After all, a company won't be eligible for inclusion in the index until it grows to a certain size, so you'll automatically have missed the best high-growth period that the stock went through to reach large-cap status. Similarly, once it's in the index, a stock may well have to fall a long way before it gets so low that Standard & Poor's tosses it out of the index.
How now, Dow?
Nor is Standard & Poor's unique in its decision-making prowess. The Dow Jones Industrial Average has had well-documented bad timing in some of its choices. Adding big tech names at the peak of the bubble was an obvious mistake, but even in the run-up to the financial crisis, the Dow made questionable calls.
Adding Bank of America (NYSE: BAC ) in early 2008 proved disastrous for the index, as the bank stock was hit hard during the market meltdown. But then the Dow waited until after the market's lows to evict Citigroup (NYSE: C ) from the average, exposing investors to nearly the full downturn in the bank's shares.
What to do
Despite their flaws, index funds still have clear benefits. Given how few active fund managers manage to outpace benchmarks like the S&P 500 over the long haul, even the shortcomings of the companies that manage those benchmarks seem less detrimental than bad investing decisions of many fund professionals.
Never think, however, that an index is the be all and end all of investing. As a tool, it can serve you well, but you shouldn't be scared to venture beyond it seeking your own outperformance. After all, even index funds do dumb things sometimes -- and will continue to do so well into the future.
Some of the best index investments are ETFs. Find some smart ETF picks in The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."