4 Reasons Your Index Funds Failed You

Index funds, which I and most other experts recommend for investors, are supposed to make investing easy, painless, and trouble-free, producing peace of mind for their shareholders.

But sometimes they don’t.

I’ll look at four reasons you may be unhappy with an index fund, and in each case suggest what you might do to turn things around.

1. Some index funds are much too expensive.

The index funds I recommend generally have low recurring expenses, ranging from 0% to 0.25% annually, and they don’t produce this source of angst. But some index funds involve sales commissions to compensate whoever may recommend them – or simply to pad the profits of the fund sponsor.

A sales commission, or load, can take several forms. Some arrangements require an upfront payment that gets the psychological pain over with quickly but immediately reduces the amount of your money that’s invested. Others spread the commission over time and recapture it through higher annual expenses. In some cases, those higher expenses never go away.

In 2018, Barron’sreported that hundreds of billions of dollars were (and presumably still are) invested in index funds that charged more than 1% in annual expenses. Wall Street loves these funds, which are very inexpensive to manage because they essentially run on autopilot.

The magazine cited the Rydex S&P 500 index Fund RYSYX as perhaps the most expensive index fund in America, with annual expenses so high that most advisers would regard them as highly overpriced even for an actively managed fund.

The fund’s annual expenses of 2.36% have sapped its performance over the past 15 years – to nearly 3 percentage points below the index it tracks. And for investors in taxable accounts, the Rydex fund’s annual tax cost is almost 1.5 percentage points higher than that of the Vanguard 500 Index Fund VFINX.

Barron’s cited “investor complacency” as a major reason index funds can get away with such charges. 

What to do: First, check the annual expenses you are being charged. This information, if you have your fund’s ticker symbol, is readily available at financial sites like Morningstar and Yahoo Finance.

If you have invested in a load fund, it may or may not do you much good to sell in order to cut your costs. This depends on your individual details such as potential redemption fees and capital-gains tax liability.

However, you can certainly stop making new investments into such a fund.   

2. Your fund may be tracking an asset class that’s not performing as you expected.

Since 1927, there have been 145 periods of 120 months (10-year periods, in other words) in which the S&P 500 SPX index has lost money. Even the lowest-cost and most brilliantly run S&P 500 index fund can’t give you gains in times like those. 

If that’s the cause of your index fund blues, it’s not the fund’s fault.

What to do: Diversify your holdings into other asset classes (and their index funds) that have a history of rising and falling at different times and different rates compared with the index that’s disappointing you.

For example, in nearly three-quarters of the 120-month periods (107 to be exact) in which the S&P 500 lost money, a small-cap value index was profitable. For more ideas, check out my article These 7 simple portfolios have beat the S&P 500 for more than 50 years.

3. Your fund may be following an index that’s underperforming its asset class.

I know: That sounds unlikely. But very few asset classes are as simple as the S&P 500. There’s no question about what stocks belong in that index or when the list should be updated. Beyond that, the landscape can get murky.

Take, for example, the total stock market index. That should be simple, right?

Here are five total-stock-market index funds, and their most recent five-year performance, listed order of decreasing returns.

Fidelity ZERO Total Market Index Fund FZROX owns 2,679 companies, charges zero expenses. Five-year compound annual return: 9.99%.

Vanguard Total Stock Market Index Fund Admiral Shares VTSAX owns 3,833 companies, charges 0.04% expenses. Five-year compound annual return: 9.85%.

Fidelity Total Market Index Fund FSKAX owns 3,930 companies, charges 0.015% expenses. Five-year compound annual return: 9.82%.

Schwab Total Stock Market Index Fund SWTSX owns 3,531 companies, charges 0.03% expenses. Five-year compound annual return: 9.78%.

T. Rowe Price Total Equity Market Index Fund POMIX owns 1,184 companies, charges 0.21% expenses. Five-year compound annual return: 9.56%.

Last winter, Avantis, a provider of exchange-traded funds (including a few that we’ve identified as best in class), made a presentation to investors showing compound growth returns for six common small-cap value indexes.

From 2008 through 2022, those returns varied from 9.33% for the CRSP US Small Cap Value index XX:CRSPSC to 6.81% for the Russell 2000 index RUT, a spread of 2.52 percentage points. 

What to do: First, be clear at the outset what specific index you want to follow. They aren’t all the same. Second, don’t expect your fund to track some other index or some other definition of the asset class you want to own.

Read: Retirement savers: This is the most important investing decision you can make

4. Your own behavior may be the problem. (Well, certainly not you specifically; but other investors might do this.)

Investors who buy and sell index fund shares when you think the market is headed up or down are engaging in market-timing behavior. Almost always, that’s likely to be counterproductive, because consistently and accurately predicting short-term and medium-term market trends is essentially impossible.

I have described in the past the studies by Dalbar Inc. that have been showing this for decades. Morningstar has also looked into the ill effects of what it calls tactical — as opposed to strategic — portfolio management. In its latest “Mind the Gap” report, Morningstar found that in the 10 years 2013 through 2022, the average dollar invested in mutual funds and ETFs earned 6.04% annually. That was 1.67 percentage points less than the total returns (7.71%) produced by the funds on a dollar-weighted basis.

In other words, investors as a whole forfeited more than one quarter of the returns they could have received.

The lesson: Your index fund is designed to be bought and held. It can’t do its job if you’re moving money in and out while you try to second-guess the overall market.

What to do: Cut it out! If you’re going to own an index fund, buy and hold. Sit tight. Do nothing. Period. 

For more on this topic, join me for an upcoming Zoom presentation The case for small-cap value: the good, the bad and the ugly.

 Richard Buck contributed to this article.

Paul Merriman and Richard Buck are the authors of “We’re Talking Millions! 12 Simple Ways to Supercharge Your Retirement.”

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