Why I Don’t Buy Traditional “Low-Cost” Index Funds

Once you’ve established some basic investment principles to follow, there’s a good chance you’ll hear a lot about buying index funds as a low-cost way to harness the power of the stock market.

How we invest in the markets today has evolved from buying individual stocks and bonds. There’s a ton of data that tells us the more individual companies we own, the better (diversification!), so a lot of investors look to buy mutual funds or exchange-traded funds (ETFs) where a portfolio manager purchases hundreds (sometimes thousands) of individual companies for you. You essentially purchase the container that holds all the companies and benefit from economies of scale.

Just a gentle reminder - since KKFP is fully independent, I am free to invest my client's and my family’s money in mutual funds or ETFs that I believe are the best. I am not tied to any fund company, so there’s no incentive for me to sell one fund over another; I do not get paid when I invest client money in a specific fund. I want to find the funds that I believe will help my clients meet their investment goals over the long run. I also invest my personal money the exact same way I invest client money. No conflicts of interest here. I just want what’s best for everyone.

This independence means I’ve done the work of sifting through what’s honestly a wasteland of funds out there to throw out the worst of the worst - funds with terribly high fees that trade way too often (high tax cost) and don’t buy enough companies (NOT diversified). Traditional, “low-cost” index funds are honestly not that bad if that’s my only option (sometimes this is the case when I’m helping clients pick funds in their 401(k) plans, etc.), but when I’m managing money directly for you, I don’t buy these funds. Here’s some food for thought as to why I avoid them.

When you see an index mutual fund or index exchange-traded fund, this should signal to you that the portfolio manager in charge of that fund is buying the exact list of companies in a particular market index. For example, you’ve probably heard of the S&P 500 market index. This is a list of the largest 500 companies in the United States stock market. There’s a committee of people who add and delete companies from this list every so often, as companies fluctuate in size. You could technically go out and buy those 500 companies yourself, but these days, there are many S&P 500 index funds you can buy instead that do this for you.

Indeed, the explicit, face-value cost of buying one of these funds is extremely low. You can measure this cost by the expense ratio of these funds - this is not a flat dollar amount that you pay, but a percentage of the fund’s assets and will be deducted from the gross return of the fund and paid to the fund manager to cover things like operating and administrative costs.

Now, I want you to consider the implicit, hidden cost of buying one of these funds. Remember that an S&P 500 index fund manager must purchase the 500 companies on that market index list in specifically defined quantities, and they have no wiggle room to make any swaps or changes in the process. How might this drive up costs? Consider a shopping trip to the grocery store as a way of better understanding these hidden expenses.

Supermarket vs. Stock Market Shopping

I’ll admit that the number of curbside grocery order pickups for my family these days far outweighs the number of times I set foot inside a grocery store. But, when I make the trek to my local H-E-B, I use a particular style and approach to shopping as I load my cart with groceries for the week.

For one, my grocery list might look a little something like this:

• Fruits

• Vegetables

• Meat & Seafood

• Bread/Bakery

• Pantry

• Frozen Meals

This is extremely simplified for the purpose of this story, but you get the picture. The point is that I really don’t list out specifics. When I get to these sections of the store, I’m looking for items that are in-season and on sale for the week. As long as I can fill up those categories to craft healthy meals for my family, I’m pretty indifferent as to which fruits I buy, which vegetables I buy, etc.

What about if my husband, Matt, is grocery shopping for the week? He doesn’t do this very often, mainly because we follow the Fair Play approach to splitting domestic household responsibilities, and grocery shopping is one that I own. But there are still a few times when he does the shopping.

Matt’s grocery list looks a little something like this:

• Strawberries

• Honeycrisp apples

• Lacinato Kale

• Sweet Potatoes

• Vital Farms Pasture Raised Eggs

• Jasmine Rice

• Sourdough Bread

• Etc…

I’m sure you see the difference: his list is pretty specific. Matt also tends to match that list item-for-item when he makes his way through the store.

When I compare my grocery receipts to his, who consistently spends a bit more? Hy husband! He misses what’s on sale due to his laser focus on the items he needs to buy to fulfill his grocery list.

You can think of index fund managers shopping in the stock market the same way. They blindly follow their list of companies to buy and cannot consider how much they spend in the process. The main goal is to buy those companies and get them into the portfolio they manage, even if a bunch of other S&P 500 index managers are all trying to do the same thing.

And yes, there are a ton of different S&P 500 index funds or index ETFs out there you could purchase - a lot of managers all trying to buy the same thing at the same time, thus driving the price of those companies up temporarily. Not a very savvy way to go shopping, right?

Kaitlin Hendrix, CFA - a Senior Researcher and Vice President at Dimensional Fund Advisors - expands on this in her article Beware the Hidden Costs of Indexing saying that “index fund investors end up buying index additions at high prices and selling index deletions at low prices. These results highlight the importance of flexibility and efficiency in portfolio design, portfolio management, and trading.”

There are many other issues I have with index funds. A major one is that long periods between index reconstitutions (when the committee decides to change up some of the names on the market index list) can also lead to style drift—investors may end up holding assets that don’t align with an index’s stated purpose. Take a look at this quick video to see a useful visual for this concept of the reconstitution effect.

When I build an investment portfolio for a client, I prefer using funds, like those from Dimensional, that have a systematic, daily investment process, allowing for more flexibility when shopping for stocks. This helps me, as an advisor and investor, avoid the hidden costs of index investing while still providing many of the benefits of the low-cost index approach.

If you’d like customized help using your financial resources effectively to make the most out of your wealth-building years, please schedule a free consultation here or email me with questions kelly@kkfp.co

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Disclaimer: This blog post is not intended to be a substitute for specific financial, tax or legal advice. The article is for general informational purposes only. Reproduction of this material is not permitted without written permission. Dimensional Fund Advisors LP or its affiliates are not affiliated with Kelly Klingaman Financial Planning (KKFP); KKFP may offer Dimensional funds in their investment solutions.