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7 Downsides to Passive Investing and Why it Can Be Bad for Your Portfolio

Are you a diehard passive investor? Take a look at a few reasons why index funds might not be your best bet.

This story originally appeared on MarketBeat

Once upon a time, you had to buy stocks if you wanted to invest in the stock market. Then Jack Bogle, the founder of Vanguard, introduced the first indexed mutual fund in 1975. Then exchange-traded funds (ETFs) came on the scene, which are indexed to a broad market or a sector but trade daily like stocks. contributor/ - MarketBeat

Studies show that while many active funds outperform passive funds in the short term, they don't in the long term — only a small percentage of actively managed mutual funds actually perform better than passive index funds.

Many people buy index funds designed to track the performance of a particular index instead of trying to outperform it. Passive managers own all of the underlying assets in a given market index, proportionate to the index. Investors are attracted by ease of investment, low costs and less effort than an actively managed approach. Passive investing typically takes a buy-and-hold approach.

But does passive investing have its limitations? You bet. Let's take a look at a few reasons passive investing can hurt your portfolio.

Downside 1: They have preset limits.

Passive funds lock into a predetermined set of investments with little variation between funds.

Actively managed mutual funds, on the other hand, seek returns that vary from the benchmark.

Portfolio managers and investors don't have to hold certain stocks and bonds when they actively invest. This means that they have a larger set of options to select from and can also take advantage of short-term trading opportunities.

Passive investments don't follow a broad portfolio. Sometimes it's not all good to track just the S&P 500 instead of the wide gamut of available securities on the market.

Downside 2: You have less control over your investments.

When you invest in a predetermined selection of securities on an index, you can't make adjustments if you see that certain sectors or companies have started underperforming. 

You earn whatever the market earns based on the benchmark you pick and there's no deviation from that benchmark. This means your investments fall when the market declines. 

You also have no control over the individual holdings in your portfolio. You may also dislike certain companies due to moral or other personal reasons. For example, if you don't like how a company treats the environment, you can't opt out of it when it's buried in an index. Sure, you can add specific stocks to your portfolio, but you can't change the components of a particular index. 

You also can't react to the markets or control your exposure to a particular stock. If you know whether a particular stock is overvalued or undervalued, your hands are tied from changing your allocation.

If you feel constricted by a lack of control, passive investing isn't for you. Pick your own stocks.

Downside 3: Holdings are overvalued.

Stocks in an ETF are often overvalued because the largest ETFs all generally have the same stocks in their top holdings. For example, the following contain similar holdings: 

  • State Street SPDR S&P 500 ETF (SPY)
  • iShares Core S&P 500 ETF (IVV)
  • Vanguard Total Stock Market Index Fund (VTI)
  • Vanguard 500 Index Fund (VOO)

The FAANG stocks, Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOGL), together make up over 20% of the total market cap of the S&P 500. 

Here’s the breakdown of FAAMG stocks (with Microsoft added): 

  • Apple Inc. (AAPL): 6.3%
  • Microsoft Corp. (MSFT): 5.9%
  • Inc. (AMZN): 3.7%
  • Facebook Inc. (FB) Class A: 2.3%
  • Alphabet Inc. (GOOGL) Class A: 2.2%

This overexposure could lead to disadvantages. When funds focus heavily on large-cap stocks and your money goes solely into the top companies, your money can become more vulnerable, especially with regard to regulatory or even political shifts. 

Downside 4: They might not track the index exactly. 

If you expect an index fund to be a duplicate of a sector, think again. Fund managers make adjustments to individual funds, which causes differences between the fund and the index. Some index funds might actually cherry-pick parts and pieces of the index, and this nondiversification can be risky for investors.

Downside 5: You won't get above-market returns.

Passive investments will never beat the market because they form the market. When you invest in the Dow or the S&P 500, you don't automatically "get" the best companies. Instead, the companies on each of these indexes represent the market as a whole.

Just remember, average stays average. You can't outperform the market if you only keep pace with it.

Downside 6: Passive investments limit your investing knowledge and growth.

Can passive investing turn you into a slack-jawed automaton? Possibly. 

When you stick your money in index funds, you rob yourself of the chance to research and learn more about investing in the market. Any investing knowledge you could have gained goes by the wayside when you choose an index fund over picking individual stocks. You don't learn how to develop skills such as determining asset allocation, risk management or valuing individual companies. Investing can be a lifelong journey and an exciting process. Why limit your opportunities?

Downside 7: Sectors can limit your diversification.

Some ETFs only track specific sectors. You may think your portfolio is diversified because you own ETFs from different fund companies. However, a lot of them own the same stocks. For example, growth-focused funds may only expose you to large-cap tech. 

You might need to pay attention to the sectors and concentrations in various funds. For example, if you have large-cap holdings, you may need to balance those in that particular ETF with small-cap stocks.

Think Carefully Before You Choose Passive Investing

Bogle warned investors in January 2019 that there may be too many shares in too few hands. He said that index funds could one day control the U.S. stock market and said that he didn't "believe that such concentration would serve the national interest."

Yikes. If the indexing pioneer says you should think carefully about your passive investing approach, you should.