1 reason to beware index funds

Index funds like ISGLCOSTP CDI 1:1(ASX:IXI), SPDR S&P/ASX 200 Fund(ASX:STW), SPDR 500 CDI 1:1(ASX:SPY) and V300AEQ ETF UNITS(ASX:VAS) are NOT perfect.

a woman

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For the record, I think low-cost index funds are awesome. They have lowered fees and been an overall positive for our industry.

However, I think too many investors believe owning a portfolio of the following index fund ETFs means they are immune to risk.

Name Index As found on Google Finance
SPDR S&P 500 ETF Trust S&P 500 SPDR 500 CDI 1:1 (ASX:SPY)
iShares Global Consumer Staples ETF S&P Global 1200 Consumer Staples index ISGLCOSTP CDI 1:1 (ASX:IXI)
Vanguard Australian Shares Index ETF S&P/ASX 300 (INDEX: XKO) (ASX: XKO) V300AEQ ETF UNITS (ASX:VAS)

What is an ETF?

ETF stands for 'Exchange Traded Fund'.

Basically, ETFs are the love child of managed funds (called 'mutual funds' in the U.S.) and stocks. All an ETF does is make it convenient for us to own an asset. Let me explain.

Let's say that you and your friends pool your money together and start a 'managed fund' investing in bricks. You list it on the ASX and call it 'BRICK ETF' (ASX: BRICK).

Using a brokerage account, other investors can buy the ETF on the ASX. When they hit 'buy' their money flows into your fund and you buy more bricks. Simple. When they hit 'sell', you sell the bricks and pass the proceeds back to the investor via the ASX for a gain or a loss.

At the end of the day, an ETF is just a convenient way to buy something, it is just the 'wrapper' which goes around a pool of assets. Understanding what assets go into the ETF will ultimately determine whether you have made a good investment.

What is an index fund?

Index funds are simply managed funds that track something. That something is an index. For example, the Vanguard Australian Shares Index Fund tracks the S&P/ASX 300.

Back in the day to get into the fund you would fill out a form, pay the money and receive your units in the Vanguard fund. However, Vanguard wrapped the fund in an ETF structure (see the table above) and listed it on the ASX. Just like the brick example, you can buy into the fund using your stockbroking account.

Standard and Poor's (S&P) and the Australian Stock Exchange (ASX) provide the index which the Vanguard fund — and by design the ETF — tracks. It includes Australia's 300 largest shares by market capitalisation.

Market capitalisation is typically calculated as share price multiplied by the number of shares on the market. The higher the share price, the higher the market cap. Simple. We will come back to this in a moment.

A dangerous misconception

Please don't forget that almost any pool of assets can be put inside an ETF. To say: "go and buy a low-cost ETF" is bad advice. And in today's modern world: "go and buy a low-cost index fund" is also fraught with danger.

What ETF are they talking about?

What index am I following? S&Ps? The one produced by UBS? Dow? MSCI?

Who knows!

My point is you must know what index (if any!) it is tracking or assets it is buying. Otherwise you could be buying something which is totally not what you need or want. You may think you are buying shares in consumer goods companies but you get bricks instead.

1 reason to beware index funds

Over the past three years, $US 1.4 trillion (with a 't') has been pushed into index funds in the U.S., according to Investment Company Institute. Most of it has gone into traditional passive index funds, which account for $US 2 trillion of the U.S. market alone.

If we narrow our focus to index funds and ETFs that track indices such as Australia's S&P/ASX 200 we can see how a serious problem starts to snowball.

Since buying shares generally pushes up market prices, shares become more expensive for no other reason than buying. For example, if you have ever bought a small or thinly traded share on the ASX you may have noticed it pushes up the share price.

Now imagine you have billions of dollars to invest. Share prices get pushed up again… and again… and again. The problem is the fundamentals of that company have not changed!

Ultimately, we have a self-reinforcing cycle. It is a near mindless push higher and higher.

Then, share prices crash. Everyone pulls their cash from the index funds and the cycle turns on its head – causing big falls.

Foolish Takeaway

Not all money in ETFs is invested in passive investments like index funds. Virtually anything can be rolled up in an ETF: barrels of oil, gold, currencies, stamps, stocks, property… you name it! The point is to make sure you know what your ETF or index fund is doing.

And if you don't like the sight of volatility you should ensure that not all of your investments are in traditional index tracking funds and ETFs. 

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes -- and encourages -- your feedback on Google+, LinkedIn or you can follow him on Twitter @OwenRask. The Motley Fool Australia owns shares of iShares Global Consumer Staples ETF. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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