To index or not to index? That is the question

Indexing, or passive investing, is all the rage at the moment. According to research from Bank of America since 2002 over $1.4trn of assets have found their way into passive ETFs. Meanwhile, investors have been dumping actively managed funds. 

Year-to-date $260bn has flowed out of US long-only equity mutual funds, 3.9% of industry assets under management. At this rate, it will only take 19 years for US investors to dump all of their holdings in actively managed funds. Analysts at Deutsche Bank have echoed this view. They believe that within five years the size of the so-called passive ETF market could grow to $6.2trn, up from $2.2trn today. 

But should you join this trend? 

Pros and cons 

There are a number of arguments both for and against the passive indexing movement. 

Firstly, in the ‘pro’ camp, passive funds usually have lower fees than their active counterparts. Over the long term, the extra 0.5%-1% in performance gained by lower fees can really add up. Secondly, passive funds have a record of outperforming active fund managers because they’re tracking an index and there’s no risk of making a stock picking mistake — if the index does well, the index fund should replicate its performance with the only negative drag being fees. 

However, indexing has its drawbacks as well. For a start, buying the whole index may not be suitable for every investor as it confines you to averages: an average performance and average yield.

Granted, an index portfolio will make sure your returns are matched to the index you’re tracking, but is this really the best solution for you? 

An income-seeking investor might prefer to buy a portfolio of dividend champions such as Shell, GlaxoSmithKline and BAE Systems alongside an index fund. Meanwhile, a growth investor with a longer investment horizon might consider buying an actively managed fund that targets growth stocks with a few select single stock ideas added to the portfolio to give it a boost. 

Moreover, fees are a problem with index funds. Indeed, most brokers charge an account management fee, so why should you have to pay a fee to the fund managers running an index fund when a portfolio of blue chips may produce the same, if not better, result?

Depends on your circumstances 

Ultimately, whether or not you should follow the trend of indexing depends on your circumstances.

If you’re a beginner investor who can’t wait to dive into the market, it may be best to buy an index fund and learn the ropes before plunging into individual stocks. If you have some experience investing, using an index fund alongside some select stock picks may help boost your long-term returns. All in all, index funds can be helpful for some, but they’re not a blanket solution for all investors. 

Make money, not mistakes

A recent study conducted by financial research firm DALBAR found that the average investor realised an annual return of only 3.7% a year over the past three decades, underperforming the wider market by around 5.3% annually thanks to poor investment decisions. 

To help you streamline your investment process, realise and understand the most common investor mis-steps, the Motley Fool has put together this new free report entitled The Worst Mistakes Investors Make.

The report is a collection of Foolish wisdom, which should help you avoid needlessly losing too many more profits. Click here to download your copy today.

Rupert Hargreaves owns shares of GlaxoSmithKline and Royal Dutch Shell B. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.