The Pros and Cons of Indexes

There are advantages and disadvantages to using stock indexes and the index funds that track them. An index is an imaginary portfolio of securities representing a particular portion of the broader market. The stock index can provide a statistical measurement of the stock prices in that portfolio. An index is typically constructed using the shares of leading companies in the economy or in a certain sector of the economy.

Indexes first became popular with the Dow Jones Industrial Average (DJIA) created by Charles Dow in 1896. The DJIA was the second stock index, created after the Dow Jones Transportation Average. The DJIA became an important tool for tracking the strength of the larger economy. Since then, other stock indexes have become popular, including the S&P 500 and the NASDAQ Composite. There are also many indexes that track other sectors of the market such as bonds and commodities.

Many low-cost index funds track stock indexes. Some prominent investors such as Warren Buffett have championed the use of index funds for the average investor. However, there are significant negatives associated with the use of index funds.

Stock indexes provide an easy way to track the overall health of the economy. By looking at one statistical measurement, it is easy to gauge the current state of the economy. Further, the historical data of index movements and prices can provide some guidance to investors as to how the markets have reacted to certain situations in the past. This can allow for investors to make better decisions.

There are also a number of advantages to index funds. The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. This can save investors a lot of money over the course of their lives since less of their investment gains go toward fees and expenses.

Academic studies have shown index funds outperform active management funds over time. Even a manager who consistently beats the market can show diminishing performance. Thus, it often makes sense for many investors to include index funds as a portion of their portfolios.

There are issues with how stock indexes are calculated that can lead to disadvantages. For example, the DJIA is a price-weighted index. The index is calculated by taking the sum of the prices of all 30 stocks in the index. This sum is then divided by a divisor. The divisor is adjusted based on stock splits, spinoffs or other changes in the market.

Stocks with higher prices have a larger impact on movements in the index as compared to lower-priced stocks. As a price-weighted index, no consideration is given to the relative size of the industry sector of the stock or its market capitalization. Another criticism of the DJIA is it only represents a thin slice of the blue-chip universe since it only contains 30 stocks.

On the other hand, the S&P 500 is a market-cap-weighted index. It is calculated by taking the adjusted market capitalization of all the stocks in the index and then dividing it by a divisor. Similar to the DJIA, the divisor is adjusted for stock splits, spinoffs and other market changes. The drawback to the S&P 500 is the index is weighted toward companies with larger capitalizations. The stock prices for Apple and ExxonMobil have a much greater influence on the level of the index than a company with a smaller cap. The index does not provide enough exposure to smaller-cap companies.

There are also disadvantages to using index funds for investments. A major drawback is the lack of flexibility in an index fund. Stock indexes had a great deal of volatility in 2008 and 2009. The index fund merely followed the stock indexes to the downside. However, a good active manager may have been able to limit the impact of the downside volatility by hedging the portfolio or moving positions to cash. Further, index funds can only provide average results at best. There is no opportunity to outperform the market and make massive gains. There is an opportunity cost to using index funds.