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Why index funds underperform their index

by | Feb 24, 2012 | OTHER, SELF-PUBLISHED

Q – Is it true that an index mutual fund offers no chance of beating the market? Isn’t the point of such funds, including exchange-traded funds, to track the market? – Dylan S., Simcoe, Ontario

A – The simple answer is yes. An index mutual fund will not beat the market. Similarly, while it’s true that the mandate of index-tracking funds, including exchange traded funds (ETFs), is generally to track a specific index or benchmark, they will always also underperform the actual index.

The reason is simple: The fund is not free. There is a cost to managing any type of mutual fund, which could range from 1.5% to 3.5% of assets annually. Even if the fund tracks the market exactly, it will always lag or slightly underperform because of the fee associated with managing the fund. Even with low-cost ETFs, there are still expenses associated, and those expenses reduce the return slightly.

There is one way to get around this, but it’s complicated, and probably not worth the effort. If you have your own trading account, you could purchase the index components yourself. But you will lose the professional management on an ongoing basis. And you will need to stay on top of changes to the index you are trying to track. Even then, you will underperform, because you will still need to pay transaction fees to buy and sell holdings to keep the weightings and holdings the same as the index.

With index tracking funds, you are not trying to “beat” the market – you are attempting to replicate the performance of a specific index. And for this purpose, all in all, you’d probably do better with an ETF. – R.T.

Robyn Thompson, CFP, is the founder of Castlemark Wealth Management, a boutique financial advisory firm, specializing in customized financial, investment, insurance, and retirement planning. Phone             416-828-7159       or email today to rthompson@castlemarkwealth.com for a no-obligation, no-charge Castlemark Integrity Financial Planning consultation.

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Notes and Disclaimer

© 2012 by the Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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