Indexes have gone up lately, but risk levels are rising. Image source:

Index investing has taken the market by storm. Hundreds of exchange-traded funds offer nearly unlimited opportunities to track indexes from every asset class, industry sector, and geographical region of the global economy. Index investing has some major advantages over active management, but as the strategy has become more popular, it has begun to carry risks that could hurt investors' returns in the future.

Beware the crowd
Smart investors learn early on that when they find themselves agreeing with the consensus among investors, it's time to be cautious. The popularity of index investing has soared recently, as actively managed mutual funds and even hedge funds have failed to deliver the market-beating results that attract investors' money. According to fund-tracking firm Morningstar, assets in mutual funds and ETFs that passively track indexes make up more than 30% of overall fund investments.

The flood of money into index-investing strategies has created several risks for investors. The first involves the relative valuations of stocks within popular indexes and stocks outside those indexes. As ETFs like the SPDR S&P 500 (NYSEMKT:SPY) and the iShares Russell 2000 ETF (NYSEMKT:IWM) have grown more popular, the stocks within those indexes have seen their valuations rise accordingly as index funds buy their component stocks regardless of their individual fundamentals and future prospects. During bull markets, when index-fund inflows are typically higher, the effect is amplified. Therefore some fear that when the bull market ends, stocks within popular indexes will carry heightened risk, especially if investors recognize the artificial way in which their share prices have risen and take away their index-related premium.

Looking for liquidity
The other primary risk with index investing is that there can be disruptions to smooth trading if everyone heads for the exits at the same time. Mutual funds only handle redemption requests on a once-daily basis, and everyone who sells gets the net asset value of the fund shares as of the end of the trading day. For ETFs, though, the ability to buy and sell depends on the willingness of other market participants to take the other end of the trade.

Large ETFs like the SPDR S&P 500 and the iShares Russell 2000 ETF have enough investors following them that they don't have as much risk of suffering trading-related problems. Smaller ETFs, however, don't have as much trading volume. In the past, that has led to situations in which ETF share prices can fluctuate wildly, especially during market panics when investors seek to get out at any price.

The way ETFs work can also create potential hazards for investors. In times of high volatility, stock exchanges can impose trading curbs on individual stocks that move by more than a certain percentage. If a stock that is part of an ETF's overall basket is no longer available for trading, it prevents the institutional market-makers that oversee that ETF's trading activity from taking certain steps to provide greater liquidity in the shares of the ETF itself. Those institutions thus find themselves in a position where they have to take on higher risk to make a market for the ETF shares, and their reluctance to do so tends to reduce liquidity even further. Investors saw that phenomenon during the August plunge in the stock market, when many ETFs didn't trade as efficiently as hoped.

An opportunity for active investors
If index investing is inflating the prices of stocks within indexes, then it opens the door for active investors to take advantage of those improper valuations. For instance, at the sector level, the recent plunge in energy prices has reduced the weighting of energy stocks within the SPDR S&P 500 to just 7%, down from 14% in early 2009. S&P 500 index investors who think energy will rebound will need to supplement their index-fund holdings to take full advantage of a rebound, either by buying shares of an energy-specific index fund such as Energy Select Sector SPDR (NYSEMKT:XLE) or through investments in individual stocks.

In addition, looking at individual stocks outside of popular indexes can create chances to profit. First, stocks in the same industry sometimes trade at much different earnings multiples simply because one is in an index and the other isn't, and the cheaper stock can have a greater intrinsic value compared to its current price. In addition, stocks that aren't in a popular index can grow enough that they eventually get invited into that index, and share prices often rise when a stock gets added to an index that has substantial amounts of assets tracking it.

Be smart about index investing
Index investing still has plenty of benefits for investors who don't want to spend a lot of time researching individual stocks. Nevertheless, you need to be aware of the risks that index mutual funds and ETFs face in order to make sure your own risk level is in line with your comfort zone as an investor.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.