Is passive investing a trap? The real risks behind index funds you need to know

The popularity of passive investing among investors who seek low-cost automation solutions has surged through the use of index funds together with Exchange-Traded Funds (ETFs).

Most investors choose passive funds since they provide broad market coverage at lower operating expense levels. Some investors miss crucial threats that exist in their investments.

This article investigates passive investing hazards which investors should understand when investing in index funds.

1. Overweight of overvalued stocks

Market capitalisation represents the main characteristic which drives the majority of index fund operations. The index contains a larger portion of stocks that represent its biggest market values. The method works reliably in stable markets but exposes investors to major risks in fast-growing markets.

According to Nilesh D Naik, Head of Investment Products at Share.Market (PhonePe Wealth), “Since most indices that are being tracked by passive mutual funds are market cap weighted, they tend to exhibit some characteristics of momentum investing, wherein the stocks whose stock prices are on the rise tend to get higher weight in the portfolio. This can lead to index funds being significantly overweight overvalued stocks, especially towards the peak of the bull market, thus increasing the risks during a market downturn.”

When stocks perform well during bull markets they receive additional weight in the index and subsequent market declines may hurt the whole fund through these overly valued assets.

2. Lack of flexibility in extreme market conditions

A major disadvantage of passive funds includes their inability to handle market volatility changes. An index-based passive fund must follow its selected market benchmark without deviating while active fund management grants portfolio adjustments that enable risk reduction or transitions to safer investment assets.

Nilesh D Naik elaborates on this risk: “Passive funds also lack flexibility to be defensive during extreme market conditions, as their performance is typically assessed based on their tracking error with respect to the benchmark they track. For example, they cannot take any cash calls, whatsoever, even when there’s extreme valuation excess in the market.”

3. The price differential of ETFs on markets and AMCs

The popularity of exchange-traded funds (ETFs) represents a common passive investment due to their stock trading flexibility. ETFs experience deep illiquidity problems in situations when market volatility reaches high levels. ETFs present particular issues when they price significantly below or above their Net Asset Value (NAV) due to COVID-19 market events along with political incidents and similar market volatility occurrences.

4. Missed opportunities with active stock selection

Index funds often achieve low-risk status because of their extensive diversity yet they prevent investors from making stock selections for higher returns. Active investment management enables investors to generate superior performance outcomes than passive methods do.

Trivesh, COO of Tradejini, highlights this limitation: “Index funds are often seen as a low-risk investment, but they come with hidden risks. Their rigid structure means missing out on active stock selection. A high tracking error can lead to deviations from the index. Fund managers also can’t adjust holdings if a sector becomes overvalued or faces governance issues.”

5. Impact of heavy inflows on price discovery

Passive investing generates significant risks through massive inflows which people tend to overlook. The stocks within an index get more desired when investors add funds to these index-based products which distorts price discovery processes leading to mispriced stocks.

Trivesh adds, “Heavy inflows into index funds may weaken price discovery, leading to mispricing.”

Stock prices fail to reflect true company fundamentals when passive funds attract large money flows since investors purchase stocks only as a part of an index-mirroring strategy rather than for their individual company attributes. The market starts showing inefficiencies because investors stream their money into specific industries and equity sectors.

To sum up, investors should acknowledge the risks involved in passive investing. Investors should evaluate several aspects starting from price discovery disruptions to lost chances of strategic stock buying and market illiquidity together with market momentum effects.

Passive investing gives you a sufficient foundation for your portfolio, however, it requires understanding hidden risks before confirming your approach aligns with your risk management goals.