I’ve got several articles on my blog either directly or indirectly praising index funds. These days funds are the investment vehicle of choice for the discerning passive investor who wants simplicity, and they’re so much better than the investment options that were available not too long ago. We should recognise how lucky we are to have access to these effective, affordable wealth-creation tools.

However, this doesn’t mean we should passively accept their limitations (pun fully intended). The downsides of investing using ETFs and funds that track whole indices or industries, multiple asset classes, or subsets of indices are not discussed as often.

To be clear, I think the upsides far outweigh the downsides, but it’s interesting to consider how funds could be improved, and knowing about these issues could help you be prepared or take action to mitigate the downsides.

Some are just essential features of fund investing and may not be important issues for you, others you may not have even realised, and some might make you rethink how you want to invest using funds.

1. You might lose (or never acquire) voting rights

Owning shares in companies comes with the right to vote at each of these companies’ AGMs or EGMs. With index funds you might think you can therefore cast a vote on every company in an index, but this voting right is usually entirely removed, and instead the fund manager has the rights to vote on your behalf.

Maybe that doesn’t bother you. Would you really want to vote on all the thousands of companies you own a small part of anyway? Probably not; imagine the work involved to read all the documentation, understand the issues and options, and then the sheer amount of admin to vote for each proposal. But it might be nice to at least have the choice.

Shareholder activism is a very important (and overlooked) issue, as many companies are under the control of massive fund managers, hedge funds, and other large institutional investors that control a significant percentage of the votes and can swing decisions in their favour.

Having the plurality of opinions of the small retail investors is much more democratic. These smaller individual investors may be much less inclined to award absurdly high director and executive remuneration packages, or vote for the pursuit of profit regardless of the costs to the environment or society.

2. You will get lower dividend returns in exchange for greater stability

Unless you’re specifically buying a dividend fund, perhaps one that targets higher-yielding companies, your dividend returns are being diluted by all the companies in the fund that don’t pay a dividend. Instead you’re often getting the average return of the whole index, including companies that have never paid a dividend or have no intention of doing so.

Of course, we’re also benefiting from investing in a larger group of dividend paying companies, where no single company’s dividend decisions can impact the average too much one way or the other, reducing the uncertainty of the dividend yields.

It’s also harder to tell what dividends you’ve received if you invest in funds that automatically reinvest your dividends. There are income funds that pay the dividends out and you have the option to reinvest as you see fit, but there’s still a lack of transparency about specifically where your dividends have come from and how much has ended up with you after all the various charges, taxes, and other deductions have been taken.

3. You’re forced into a particular diversification

You get some choice over how you diversify by just picking another fund with different objectives or one that covers a different asset class, industry segment or geography, but these options are far more limited compared to buying individual securities yourself.

My last blog went into what a good diversified portfolio could include, but there are some ways you can diversify even when using tracker funds, though you’d need to buy a few different funds depending on what you want to achieve, which might take away from the appeal of funds being simple.

4. The fund may not actually track the index accurately

This is a technical problem called tracking error and it means the daily swings in the market are not replicated exactly by the fund’s replicating portfolio. This is less likely in full replication portfolios that own all of the stocks in full, but if there are hedging methods used to replicate it artificially with derivatives it may differ from the actual in either a negative or positive direction.

The daily deviations can add up over time to a significant cumulative tracking error, meaning the return of the index may not be the return your fund provides. An interesting question is what happens when the market declines significantly and you hold a non-replicating fund which uses derivatives to replicate the underlying index? Are you at higher risk of the derivative-based fund not responding like the index itself? Is this a risk worth taking for the lower expense cost?

What if the fund manager goes bust (an unlikely thing to happen given how vast these companies are)? If it’s fully replicating, the assets can just be sold at market value. But what if it’s derivatives? These are fringe problems, but there’s usually a price to pay for lower expense ratios.

5. Expenses for complex funds can be higher

The simpler the fund objective, and the larger and more liquid the market, the lower the expense charge will generally be.

Fund Name	Expense Ratio	Fund Objective
Vanguard S&P500 Tracker	0.03%	Track the S&P500 index
Vanguard S&P Mid-Cap 400 Growth ETF	0.10%	Track the S&P MidCap 400 Growth Index
Vanguard Real Estate ETF	0.13%	Track the MSCI US Investable Market Real Estate 25/50 Index by investing in REITs
Vanguard High Yield Active ETF	0.22%	Actively managed junk bond fund

Commodities, higher yield, more companies tracked in the index, full replication rather than using derivatives, niche sectors or investment objectives, active fund management. All of these cost the fund managers more to administer and this gets passed on as a higher expense charge. How much extra return do you get for this extra cost and is it worth it in the long run?

Typically you’ll pay more for additional choice and complexity so you need to consider if this would help you meet your investment objectives. The higher expenses of actively managed funds are seen as a waste of money by many, given the returns these funds produce compared to cheaper passive funds, but they do have their place.

6. Data for tracking investments is less available and less frequent for the underlying assets

It’s hard enough to get good free data on investment securities generally. Getting frequent, granular data on the underlying investments in funds is almost impossible, let alone processing into a manageable format for analysis, and then maintaining and updating it. A PDF document once per quarter is about all you get in many cases.

It’s not even complex information that’s lacking, it can be as simple as the proportions of the fund holding for each company, the jurisdiction of the assets, the prices bought and sold at, and the industry category.

I’m not sure what value having this information would offer most retail investors. It would enable me to track how the specific indices I want to track have changed over time, and to adjust the proportions and rebalance my mix of the different funds according to my investment objectives and diversification requirements.

I appreciate this is beyond what most investors are using funds to achieve, but having more data can lead to more insight and that’s valuable if you’re willing to do some of the extra work involved.

7. You’re implicitly supporting sin stocks with no way to opt out

This is a problem if you invest in funds that track the whole index. Many industries are engaged in practices that groups in society find unacceptable or distasteful and would not choose to support them by having these companies in their portfolios. This can include alcohol, tobacco, defence companies, oil and gas, etc.

The problem with index funds is that the you’re automatically invested in these companies if you want exposure to the whole index.

Many of these “sin stocks” are also some of the more profitable companies, and they tend to do well when things are going bad in the economy (so called defensive stocks), and as an added downside, if you use funds that exclude these stocks (for example as part of an ESG objective), you’ll probably end up paying higher fees for that decision, and the returns may be in fact be disappointing compared to the index as a whole.

How much are you willing to flex on your values and morals for your investment returns?

8. You’re adding to the passive pile-in problem affecting liquidity

As I’ve mentioned in another blog post, there’s a liquidity problem emerging with the increased use of passive funds. Not many people are actually choosing the best stocks anymore (apart from the hedge funds who profit from exploiting the passive investment inflows) so every company is being supported.

This approach to investing is creating a feedback loop of increasing, sometimes unearned, higher valuations, and this allows the institutional investors to exploit the market inefficiencies at the expense of the retail investors and is potentially setting up a point of failure that does not seem to be well understood.

9. You’re propping up the big players at the expense of the SMEs

The funds that track whole indices inherently support the bigger companies, since the inflows of cash often go in proportion to the market capitalisation, and the US market in particular is heavily overweight in particular segments (technology stocks), and by a very small number of companies.

The smaller companies, where a lot of innovation traditionally used to happen, are at a disadvantage if they aren’t in the top echelons of the index, and getting that automatic boost to their share prices each month.

It’s therefore also creating a competition in which smaller companies feel the urgency and importance of racing to get into the index so they can tap into this stream of investor cash. The power of the incumbents and monopolies increases under this system.

Conclusions

This may seem like a lot of problems, and many without a solution or at least an easy one. The quantity of problems is however outweighed by the big benefits of index funds, and despite these issues I would still (and do) use index trackers to pursue my investment objectives. An awareness of the limitations is valuable knowledge and means we are making a more informed choice, which is no bad thing.

These are all legitimate concerns that can mostly be addressed, but it’s important to think in the context of history and what investments we would have been able to access many years ago. The industry has moved on for the better in many ways, and no doubt these issues will be addressed in the future and the costs will continue to come down, and the data, service and customisation will further improve.

Would any of these issues put you off investing in index funds? Which are the biggest concern to you, and which are you willing to let slide? Thanks for reading, until next time.