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3 Reasons to Move Beyond Index Funds

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Index funds give investors a low-cost, low-stress way to build a diversified investment portfolio. If you want to take your investing prowess to the next level, though, you'll want to move beyond index funds -- at least with part of your savings.

Simplicity at a price
Index funds have revolutionized the investing world. From their origins with Vanguard's Index 500 fund, index funds have spread to cover much more than just broad stock indexes. Especially since the advent of exchange-traded funds, you can now find index-tracking funds that follow just about any type of investment you want, from municipal bonds to small-cap emerging market stocks to the price of natural gas.

Whether you're talking about a commodities ETF or a vanilla S&P 500 stock index fund, what every fund has in common is this: It tries to mimic its chosen index. And while that makes for simple, inexpensive management, it also has shortcomings.

1. You own the bad with the good.
One of the benefits of owning a broad-based stock index fund is that you own small pieces of a large number of companies. But almost by necessity, you'll own a number of bad companies -- ones you would never buy on their own as individual stock holdings.

For instance, within the S&P 500, you'll find all sorts of struggling companies. Along with up-and-coming stocks like Flowserve (NYSE: FLS  ) that contribute to positive performance for the index, there are arguably struggling businesses like The New York Times Co. (NYSE: NYT  ) and AIG (NYSE: AIG  ) weighing them down.

Moreover, index companies can be slow to remove stocks that no longer meet their standards. For instance, when General Electric (NYSE: GE  ) cut its dividend in early 2009, it no longer qualified for the Dividend Achievers index. But an ETF tracking that index still had the stock in its portfolio as of Dec. 31, because it didn't sell the stock until the quarterly or annual rebalancing took place. Similarly, S&P didn't remove Fannie Mae (NYSE: FNM  ) and Freddie Mac from the S&P 500 until after their devastating drop.

2. You're captive to index weights.
Even if you're willing to put up with owning some bad stocks to keep your investing simple, index funds limit you further by dictating how much of each stock you should own.

For instance, take the SPDR Health Care Select ETF (XLV). It purports to give broad-based exposure to health-care stocks. But when you look at its holdings, you'll notice that fully 25% of its assets are dedicated to just two stocks: Johnson & Johnson (NYSE: JNJ  ) and Pfizer (NYSE: PFE  ) . You'll often see that phenomenon with index funds weighted by market cap. If you want to emphasize small stocks over bigger ones, then you'll have difficulty with index funds.

3. You stop trying to be a better investor.
Indexes make investing easy. Yet if you're not careful, you can end up relying so much on index funds that you never even learn how to analyze an individual company. That's fine if you're satisfied with market-matching returns, but if you want to become a better investor, there's no substitute to finding great stocks through your own research.

That doesn't mean you have to put all of your money into a portfolio of individual stocks. One smart way to get started with individual stocks is to take a small portion -- perhaps 5% or 10% of your total portfolio -- and dedicate it toward investing in some specific companies. Even tracking just a few stocks can put you much more in tune not just with those companies' prospects but with the health of the overall economy as well.

Think about it
Index funds have made smart investing possible for every investor, yet despite their benefits, they're not a perfect solution for all investors. If you want to work at becoming the best investor you can be, then you'll want to move beyond index funds -- and you'll find the effort well worth it.

If you're just getting start with investing, be sure to take a look at our How to Invest collection. You'll get the tools and information you need to invest right away.

Fool contributor Dan Caplinger is always moving forward. He owns shares of General Electric. Pfizer is a Motley Fool Inside Value pick. Motley Fool Options has recommended buying calls on Johnson & Johnson, which is a Motley Fool Income Investor pick. The Fool owns shares of Flowserve. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy goes beyond the ordinary.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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