March 18, 2012

The hidden danger behind index funds

When buying a fund to invest your money in for a profit, you can buy an index fund or choose the more risky managed fund:
  • The index fund follows the underlying index no matter what. If S&P 500 increases with 5 percent, the index fund increases with 5 percent. 
  • You can also pay someone to choose stocks for you in a fund that may increase more compared to the index fund. If you invested in a fund where someone like Peter Lynch is the one who is choosing the stocks, you probably made a lot of money from it, but that is often not the case. Most managed funds have poor performance, sometimes they are actually worse than the index fund. 

Many people have lost their faith in their fund managers - they don't think the fund managers are worth the money they cost when the performance of the fund is poor. So, the amount of money invested in index funds around the world is increasing each day. This is however not something good if you believe in index funds.

The problem when the amount of money in index funds is increasing is that the underlying index is being affected by the money invested in it. If you invest in an index fund, the fund invests in the underlying index with your money. More than $1 trillion is currently invested in index funds. With so much money, some index funds have stopped to following the underlying index - the index funds have become the index.

Source: The Psy-Fi blog