The Problems With Index Funds

An overwhelming body of evidence demonstrates that the majority of investors would be better off if they adopted indexed investment strategies. And while a total-stock-market index is fine for many investors, indexed investors who desire certain types of exposure face a number of problems. These problems can be addressed with what I call “structured portfolios.”

The benefits of indexing relative to active management are clear:

  • Low expense ratio
  • Low turnover, resulting in relatively high tax efficiency and relatively low transaction costs
  • Limited risk of style drift
  • Minimal cash drag
  • Total transparency

Indexing provides all of the above benefits, but it does come with some negatives because the sole goal of index funds is to replicate the indices they are tracking. Index replication and the minimization of tracking error to avoid results different than the index itself come with costs.

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