Investor Questions Podcast

2 major problems of Index funds you need to know about.

There are many ways to invest your money but they all can be categorized into two main categories; active investment and passive investment.
Active investment is when you buy and sell, you are actually dealing with the market while passive investment means you only take what the market is offering and for most people passive investment means index funds.
Index funds is like any other investment have risks; yet the risks of index funds are higher and that is why you need to understand them deeply before deciding to invest in them. You may not be able to avoid the damage but at least you may minimize it. Let’s see two of the major risks of the index funds and how to deal with them properly.

The high trading costs:
Forced transactions lead to these high trading costs and to fully understand this let’s imagine that your index fund buys and holds stocks in a certain range. One of the stocks was in the range in a certain period of time then it went out of it; it is when the index fund should sell the stock. A year later, the same stock is within the range again so the index fund buys and holds it again.
It is a non-productive turnover.

There is a solution of this problem by a system called” hold ranges”. The fund will buy the stocks that are higher than a certain number and the fund will determine a range of stocks below this number that will be just hold not bought. If the stock comes out of the hold range, it will be sold.
This will reduce the costs and improve the tax efficiency.

The in-built diversification that you as an investor think you have is just overexposure to financials.
There are three points to discuss here.
• Don’t own many stocks in the same diversification. We agreed that the index funds are full of risks. So you don’t want to have a high number of your own stocks exposed to the same risk.
• Small actively managed index funds are better than the large ones.
• The index funds have heavy weighting to banks and the resources sector so if you are investing in an index fund, take care of this point. Lower your expectations about the in-built diversification.

So what are the solutions here?
Well there are several points to consider.
• If you gave your portfolio an index tracking base, perhaps you should consider the following points:
– Put only about 30% of index fund capital into your tracker.
– Supply it with overseas funds.
– Supply it with a low cost, actively managed, local funds that don’t have high weightings in banks.
• You can give your portfolio a real diversification when you fill it with some non-financial, non-resources chips.

Every problem in the investment industry has a solution. The problems of index funds may seem dangerous and difficult to be avoided, yet when you know the risk well, you will know how to deal with it. It is an excellent investment so just do your research before deciding to join it.

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