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The market calls of index investing

  • Index investing takes the thought process out of stock picking. But you first have to select the right fund.
  • A local bias in index investing greatly exposes investors to the ups and downs of the U.S. markets.
  • Make sure "to dig into the underlying product," warn advisors, so you know how your index invests.
Index investing takes the thought-process out of stock picking.
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Index investing takes the thought-process out of stock picking.

Index funds have eased much of the decision-making process of investing, except when it comes to selecting your strategy.

When financial advisor Tim Courtney evaluated a prospective client's portfolio last year, he found the entire savings was placed in a myriad of different index funds. A good sign — had they not all tracked the same large U.S. company indexes.

If an economic headwind came blowing through large-cap stocks, the client's entire portfolio would suffer, because each investment would "behave very similarly," said Courtney, who is CIO of Exencial Wealth Advisors.

Courtney's client sought the comfort of index funds but failed to realize that by investing entirely in U.S. large-cap companies, she inherently made a call on the market: that the only safe haven was in large American stocks.

As investors flood index funds with new investments, they're taught that it's the passive strategy that will perform long-term. And it's true; passive index funds outperform most active managers over a 10-year period. But that doesn't mean you're not making investing decisions.

When you first pick your funds, you're making a call on the market or having your internal biases play a role in the index you choose. This leaves you susceptible to common oversights.

A fondness for local

Courtney's client isn't nearly as diversified as one might imagine.

By having money spread out in different funds tracking the Russell 1000 index, "it makes it seem like you're diversified," said Courtney. "But they're all behaving the same way."

Anything that creates trouble for large firms will impact the client's entire portfolio. That's fine in times when U.S. funds are rising, like in our current eight-year bull run. When a market correction comes, though, there's no protection in place.

Also, by betting solely on U.S. firms, the client gains exposure to 53 percent of the global market capitalization created by American companies while ignoring the 47 percent provided by firms headquartered around the world.

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It's very common for clients to come to advisor Robert Gerstemeier's office saying they want to avoid international companies due to this local bias. Gerstemeier, a CFP and founder of Gerstemeier Financial Group, likens this strategy to a baseball team that has nine players on defense, all standing in right field.

It's true that U.S. firms have outperformed. Vanguard's Total International Stock Index has seen 1.8 percent annual returns over the past 10 years compared to 7.4 percent for the S&P 500 index fund Vanguard offers. But even having some exposure to international funds provides protection in case the U.S. economy takes a hit. "It may not be the best left fielder, but it is going to stay in left field," said Gerstemeier. One large-cap U.S. index fund can't provide that diversification.

Weighting your investment

Some parts of selecting index funds have become ingrained since their creation. One of the more common examples of this is the use of cap-weight funds, which balance holdings based on the size of the companies it invests in. That's opposed to equal weighting or having the same amount of shares of each company, no matter the size or performance.

Since Vanguard used cap-weighted strategies when its index funds grew in popularity, it has become the de facto tactic. As a result, an S&P 500 index fund currently has 20 percent of assets invested in 10 companies, such as Apple and Microsoft, since they're larger than other firms in the mix.

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If the fund is equal weighted, you must rebalance more often, since price changes will increase the weight of better-performing names. This rebalancing impacts fees. But equal-weight strategies can provide momentum, since there's more exposure to growing companies.

Based on annualized returns, the 8.3 percent for the Guggenheim S&P 500 Equal Weight ETF outperformed the 7.5 percent return from the cap-weighted SPDR S&P 500 over the past 10 years. But because of the rebalancing needed in the equal-weight fund, fees on Guggenheim's option are 0.2 percent compared to 0.09 percent for SPY. And equal-weight indexes often come with higher volatility.

No matter which choice you go with, make sure "to dig into the underlying product," said Gerstemeier, so you know how your index invests.

The cost of hidden indexers

Fees separate index funds from active management. The low fees add up to hundreds of thousands in savings over a lifetime, no matter how the funds perform.

But some funds have started to entice index savers with complex strategies, like finding dividend providers or seeking higher profitable companies. The more detailed your strategy, "the more you're entering into an active managed type of ETF," said Gerstemeier.

Worse, often these types of ETFs will have an active manager in place, then simply track an index and charge higher fees. People swaying between index funds or active management may find having a human element enticing, until you lose your returns.

"You get something very much like the S&P with some tweak," said Courtney of Exencial Wealth Advisors. "But even with the tweak, [the fund] trails the benchmark."

It's a widespread issue. European advocacy group Better Finance found that 16 percent of European active managed funds it examined from 2010 to 2014 were closet indexers.

It's another example of how the rise of index funds has forced the financial industry to find new offerings, which requires investors to remain vigilant when picking and choosing.

— By Ryan Derousseau, special to CNBC.com

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