Nothing Is Perfect: The Pros and Cons of Index Funds

It's impossible to deny that index funds are a powerful tool in building your portfolio. After all, where can you gain exposure to hundreds or thousands of stocks representing different companies, sectors, and geographic regions?

Here, we'll look at the pros of investing in index funds and examine the not-so-attractive aspects to consider before investing.

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Pros

Here are some of the easy-to-identify pros of buying an index fund.

Broad diversification: Index funds invest in a broad range of securities that mirror whichever specific market index they track. For example, the Invesco QQQ Trust (NASDAQ: QQQ) tracks the Nasdaq-100 and seeks to match its performance. And with that one simple purchase, you own a stake in around 100 stocks representing the largest nonfinancial companies listed on Nasdaq. Instant diversification is tough to beat.

Low fees: Most index funds are passively managed, which means you don't pay for advisors and expense ratios tend to be very low.

Strong long-term performance: Broad market indexes have historically outperformed most actively managed funds over decades. This is primarily due to low fees and consistent exposure.

Simplicity: You don't have to be an investment whiz to profit from a good index fund. Let's say you invest in the Vanguard S&P 500 ETF (NYSEMKT: VOO). You know exactly which index is being tracked from the very beginning, and you can easily examine the underlying holdings. That's not to say that index funds are only for beginners, but they're certainly a good place for a novice investor to begin.

Cons

As with most things in life, index funds also have a downside. For example:

Full exposure to market swings: Most index funds eliminate manager risk. However, they can't eliminate market risk. When the market hits a rough spot, your index fund will be affected, too. That's why it's so important to ensure your portfolio has an appropriate mix of stocks, bonds, and cash that matches your risk tolerance and timeline.

Average returns: Index funds don't typically provide the types of returns that will blow your hair back. They're specifically designed to deliver average market returns rather than outperform the indexes they track.

You may need more than one fund: Imagine that you put your money into an iShares Russell 2000 ETF (NYSEMKT: IWM). This exchange-traded fund exclusively invests in small-cap stocks in the U.S., meaning you may not be as diversified as you believe you are. You might need to purchase mid- and large-cap stocks, as well as international or emerging-market stocks, to find the balance your portfolio needs.

The beauty is that you can invest in diverse stocks on your own or purchase index funds that do it for you.

Dana George has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.