5 Common Misconceptions About Index Funds

This article is part of Morningstar's Guide to Passive Investing special report.

The incredible surge in assets that passively managed products have experienced over the past decade has largely been chalked up to costs. Individuals investors are increasingly aware of the importance of expenses in improving their take-home returns; index funds and ETFs enable them to build well-diversified portfolios on the cheap. Advisors, too, realize that their clients are cost-sensitive: With only so much of the fee pie to go around, they figure that it's better to put investors in low-cost index funds so they can take a decent cut of their own.

But I believe there's another reason for the incredible asset inflows into passive products: Many investors desire to simplify their financial lives, and ETFs and traditional index funds give them a way to do that. The bulk of new assets moving into passive products--whether traditional index funds or exchange-traded funds--are flowing into utilitarian, ultradiversified products: total U.S. and international stock and bond index funds. Not only are these products the cheapest index funds on offer, but they provide exposure to giant market segments in a single shot. That makes portfolio oversight and rebalancing a breeze.

Yet even as core index funds and ETFs are incredibly transparent and straightforward, some investors remain confused about what index products can and cannot do for their portfolios. Here are five common misconceptions that can trip investors up.

'All Index Products Are Tax-Efficient' Yes, broad-market equity index funds and ETFs have tended to be quite tax-efficient, thanks to their low turnover. And equity ETFs have additional tax-efficiency benefits, in that their managers--unlike traditional index fund managers--are unaffected by investors' buying and selling, as outlined here.

That's not to say that every index fund has been or will be tax-efficient, however. While the big, capitalization-weighted traditional index funds and ETFs have seen massive inflows, sizable redemptions have rocked some index funds and ETFs in recent years, triggering security sales and large capital gains distributions, as discussed here.

And if the index that an ETF or traditional index fund tracks results in frequent trading and turnover, that too can result in meaningful capital gains distributions. In a 2017 assessment of the ETFs making the largest capital gains distributions as a percentage of their net asset values, Morningstar analyst Dan Sotiroff noted that several of the culprits tracked indexes with high turnover. For example, SPDR Russell 1000 Momentum ETF ONEO has a one-year tax-cost ratio of 2.35%, in part because its turnover rate topped 100% in 2017.

Investors aiming to limit the drag of capital gains distributions in their taxable accounts would therefore do well to focus on plain-vanilla, market-cap-weighted equity funds and ETFs, which have low turnover and have historically kept a lid on those distributions. Investors seeking additional safeguards against unwanted distributions can find them in ETFs (rather than traditional index funds); investors in the latter can redeem their shares at any time, which can force a manager to sell to raise the cash.

It's also worth noting that the index structure confers no particular advantage unto bond index mutual funds, whether traditional index funds or ETFs, as discussed here. That's because the bulk of a bond investor's total return comes in the form of regular income distributions from the bonds in the portfolio, and those income disbursements happen regardless of the receptacle the investor uses to hold the bonds. The only way for bond investors to reduce the drag of taxes is to focus on municipal bonds, whose income is free from federal and in some cases state and local taxes.

'All Index Products Are Cheap'

Yes, most index assets are in very cheap products, and that trend has hastened in recent years. But that's not to say that all index funds and ETFs are bargains. While core, capitalization-weighted index funds can be had for well less than 10 basis points at this point, 443 ETFs and 412 traditional index funds recently had expense ratios of more than 0.75%. Most of these more expensive traditional index funds and ETFs pursue complicated strategies and/or have attracted little in assets, but larger funds with simple, cap-weighted approaches can be costly, too. One notable example is

It's also worth noting that ETF investors can confront additional fees, above and beyond their funds' expense ratios. While commission-free ETF platforms have proliferated at brokerage houses recently, investors may pay commissions to buy and sell certain ETFs. Those costs aren't a big deal for buy-and-hold investors purchasing large amounts, but can rack up for smaller investors who trade more frequently. In addition, ETF investors can face additional costs, such as premiums and discounts, bid-ask spreads, and market-impact costs. Those costs can be especially onerous for investors trading large dollar amounts in funds that trade infrequently or have illiquid holdings.

'Index Funds Are Always Cheaper Than Active Funds'

Yes, index funds are far cheaper than actively managed funds on an asset-weighted basis. That low-cost advantage helps explain why passive funds have generally crushed their active counterparts in

. But in a handful of cases, the cheapest active product in a category may actually be cheaper than most if not all of its passive alternatives. One great example is

'ETFs Are Better Than Traditional Index Funds' To be sure, exchange-traded funds have gathered the most buzz-and assets--over the past several decades, and much of the asset management industry's new product development has been concentrated there, too. But for investors who are inclined to index, ETFs aren't automatically better than traditional index funds. The "best" product type for a given investor depends on that investor's habits, assets, and the features he or she seeks. An investor who values intraday trading flexibility and airtight tax efficiency may well prefer an ETF, but a buy-and-hold type may find that a traditional index fund can be just as cheap and effective as the ETF. This article delves into how ETFs and traditional index funds compare on various measures, such as expenses, tax efficiency, and trading flexibility.

'All Market Segments Lend Themselves Well to Indexing' At this point, every reasonable market segment that an investor might want exposure to--and even some they shouldn't want exposure to--has been turned into an index fund or ETF. ETF purveyors have been especially prolific in terms of pursuing new and often arcane strategies. But just because index funds cover almost every conceivable nook and cranny of the market, that doesn't make them worth buying. Indeed, Morningstar's passive strategies research analysts have noted that certain market segments lend themselves better to active management than passive. Categories with liquidity constraints (where the securities the fund invests in may not trade frequently) are a mismatch with the constant liquidity afforded to ETF investors. In this camp, Morningstar's passive strategies researchers have pointed to high-yield bonds and floating rate/senior loan funds, arguing that a low-cost actively managed product can make more sense in those liquidity-challenged markets. In addition, Morningstar's ETF research suggests that most liquid alternative ETFs don't make the grade.

A related issue is that the cheapest index funds typically weight their securities by market value, which may or may not be a desirable way to approach a given market segment. Strategic beta products use alternative weighting schemes to help address this issue, though their alternative weighting schemes can entail additional costs.