What are the limitations of Index Funds?

Index funds suffer from three key disadvantages owing to their passive style. They don’t offer flexibility to the fund manager in managing market downsides. If the index being replicated by the fund is generating negative returns due to unfavourable economic or market conditions, an active fund manager has the option to choose stocks to better manage the downside. But an index fund must follow the benchmark, both during market up and downswings.

An active fund manager tries to generate alpha i.e. an excess return over the fund’s benchmark. Hence active funds can generate returns higher than their benchmark by taking additional risk. But index funds are low-risk products that simply mimic an underlying benchmark. Hence an investor seeking return in excess of the benchmark index should avoid an index fund as they generate average market return.

While index funds are meant to follow an index and deliver returns in line with it, in real life most index funds lag their benchmark returns due to the presence of tracking error. An index fund incurs cost every time it has to adjust its portfolio following changes to the composition of its index. The index doesn’t incur any such transaction costs when its composition changes. The transaction costs incurred by the index fund lower its return vis-à-vis its benchmark return.