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The Big Mistake Index Investors Make

http://www.fool.com/investing/etf/2012/07/10/the-big-mistake-index-investors-make.aspx

Dan Caplinger
July 10, 2012

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.

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