A reader says, “Dear Sir, you have convinced us with clear data that most active funds cannot beat the index and that index funds are the way to eliminate high fees and fund manager risk. However, does this mean index investing is risk-free? Are there any risks with index investing? Kindly elaborate with an article”.
Nothing is risk-free. The risks associated with the index or passive investing (at least in the broad market or capitalization-based index funds) are far lower than those associated with active funds.
1. Curation risk: The index curation can change the stock inclusion rules to accommodate corporate events like mergers, demergers, etc. Change the formula for computing PE, PB, etc. See: RIL Demerger: Curation risk in passive investing
2. Concentration risk: The weight of stocks in a broad market index like the NIfty, NIfty 100, NIfty Midcap 150, etc., are determined by the free float market capitalization (no of stocks freely tradeable). This means a few stocks hold most of the weight.
Typically, 50-60% of the total Nifty weight is governed by the top 10 stocks. So even if we buy a Nifty 500 or a Nifty Whole Market Index fund, those top stocks would still determine the returns. See Groww Nifty Total Market Index Fund Review.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
So, any negative development in these top stocks would suddenly impact the index. Yes, it would recover soon, but the journey will not be easy to bear, thanks to social media.
3. Arbitrary definitions for factor indices: An industry expert warned us that factor indices are often the result of data mining with arbitrary definitions to make past performance look great: Data Mining in Index Construction: Why Investors need to be cautious.
Whatever the reason, the risks of investing in factor indices soon came to light: Why Nifty Midcap150 Quality 50 index performance is a warning for factor investing fans. Also see DSP Nifty Smallcap250 Quality 50 Index Fund Review.
4. Sudden change in expense ratios: Like with any product, AMCs keep the expense ratios small to invite the AUM and then jack it up once their targets are reached. See: The Expense ratio of my index fund has doubled! Should I switch to ETFs?
5. Is there a risk in the cash component to compensate for higher TER? When AMCs jack up the expense ratios, they often need to compensate for it by taking on a bit more risk in the “cash” component of the portfolio.
Take, for example, securities lending. Here, stocks are lent to a borrower, who must return the stocks along with dividends and any other corporate benefits on a pre-agreed date. This is an exchange-traded product. So, the process is anonymous with a settlement guarantee.
However, in case of need, the fund may be unable to return the stocks quickly or may have to do so at a loss. This risk is reasonable but higher than keeping some cash in a fixed deposit.
6 Lack of Awareness. As with any product, this is a risk, especially with ETFs. Many people incorrectly believe that lower expenses imply higher returns. Many still use the NAV to evaluate an ETF instead of the price. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns! Caveat: The higher return of an index fund may arise from the risk mentioned above. Also see: Is tracking difference better than tracking error to evaluate passive funds?
We publish monthly Index fund screeners and ETF screeners to address these issues.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)