The Do’s & Dont’s of Index Investing
Introduction
The founders of KinneyMunro Wealth Advisors have a combined 60 years of collective experience managing and advising institutional investors, including pension funds and endowments, on market index strategies. This expertise provides us with perspective on how individual clients should be selecting index-based investments where suitable, while highlighting risks to potentially avoid. This paper outlines three key “do’s and don’ts” we believe investors often overlook when investing in index-based strategies.
Do: Invest in Broad Market Index Strategies for Cost-Effective, Transparent Exposure
How portfolios take market exposure matters. Broad market index funds, such as those tracking the S&P 500 or MSCI World Index, provide diversified exposure to a wide range of companies at low costs. These funds typically have expense ratios ranging from 0.03% to 0.10%, compared to actively managed funds averaging 0.82% (1). Research indicates that low-cost index funds may outperform a majority of actively managed funds over long periods of time as fees paid to active managers o!en detract from the positive pe#ormance generated in those strategies. (2).
Don’t: Avoid Index Strategies with Restrictive Constraints
Beware of highly constrained benchmarks. These portfolios are often marketed as “enhanced” or “customized” index exposures. Index strategies with constraints, such as capped weights, environmental, social, and governance (ESG) restrictions, or screened products, may limit diversification and increase costs. Research suggests that ESG constrained indices may underperform broad market indices by approximately 1.2% annually due to sector biases and reduced diversification. (3) We aren’t suggesting investors should avoid allocating to ESG strategies, just do it for the right reasons. Capped weight indices may also deviate from market performance by limiting upside growth and increasing porfolio turnover, potentially introducing unintended risks.(4) Investors should assess whether such constraints align with their long-term objectives.
Do: Select Indices with Established Performance Histories
Not all indices are created equal. Indices with long performance histories, such as the S&P 500 (established 1957) or MSCI World Index (1969), provide extensive data on risk and return characteristics. The S&P 500 has delivered an annualized return of approximately 10.7% from 1960 to 2022.(5) Established indices typically offer greater liquidity and lower tracking errors than smaller, less established benchmarks. Investors should review historical data alongside current market conditions to determine what index best suits their individual strategic needs.
Don’t: Rely on Strategies Based Solely on Back-Tested Results
When was the last time you saw a back-tested model that showed poor results? Strategies relying on back- tested results, rather than actual performance, carry risks of over optimism. Research indicates that 60% of back-tested strategies fail to replicate hypothetical returns in live markets due to data overfitting.(6) Investors should seek to prioritize indices and strategies with verifiable performance histories.
Do: Evaluate Managers with Consistent Benchmark Track Records
Choosing the right manager matters. When selecting index strategies, consider asset managers with a history of performance against a consistent, relevant benchmark spanning over 10 years of performance. Studies show that managers with stable benchmark alignment may outperform peers by approximately 0.8% annually, reflecting disciplined execution.(7) Low tracking errors, averaging 0.15% for top-performing index managers, indicate reliability.(8) Investors should review manager performance to assess consistency and alignment with investment goals.
Don’t: Engage Managers Who Frequently Change Benchmarks
Have you ever asked the question, “why has my performance benchmark changed?”. Managers who frequently change benchmarks or select benchmarks that do not reflect the risk of the strategy and return profile may obscure performance. Research shows that 25% of index funds changed benchmarks over a decade, with 70% underperforming their original benchmark by approximately 1.5% annually. (9) Such practices may mislead investors about risk and performance. Investors should ensure benchmark consistency and appropriateness.
Conclusion
Index investing can be a valuable component of a diversified porfolio strategy, offering cost efficiency and transparency when executed thoughtfully. Research supports the benefits of broad market index exposures while highlighting risks in relying on constrained indices, back-tested strategies, and managers that exhibit inconsistent benchmark use. At KinneyMunro Wealth Advisors we believe that index investing is a foundational component of portfolio construction. We prioritize the selection of appropriate benchmarks and conduct thorough due diligence on managers’ ability to deliver performance that meets our clients’ objectives.
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Disclosures
This material is intended for informational/educational purposes only. It should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial, tax, and legal professionals for more information specific to your situation. Hypothetical examples contained herein are for illustrative purposes only and do not reflect nor attempt to predict actual results of any investment. The information contained herein is taken from sources believed to be reliable. However, accuracy or completeness cannot be guaranteed. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal or objectives will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions. Investment advisory services are provided through Mariner Platform Solutions, LLC (“MPS”). MPS is an investment adviser registered with the SEC. Registration of an investment advisor does not imply a certain level of skill or training. For additional information about MPS, including fees and services, please contact MPS or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you invest or send money.
Footnotes
1. Morningstar, “U.S. Fund Fee Study,” 2023.
2. Vanguard, “The Case for Low-Cost Index-Fund Investing,” 2024.
3. University of Chicago, “The Pe!ormance of ESG Indices,” 2022.
4. S&P Dow Jones Indices, “Impact of Capped-Weight Strategies,” 2021.
5. Standard & Poor’s, “S&P 500 Historical Performance,” 2023.
6. CFA Institute, “Back-Testing Pitfalls in Investment Strategies,” 2021.
7. Morningstar, “Manager Performance and Benchmark Consistency,” 2024.
8. Barclays, “Index Fund Tracking Error Analysis,” 2023.
9. Journal of Finance, “Benchmark Switching in Index Funds,” 2022.