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.
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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.