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A Danger of Index Investing

Published on: Apr 28 2017

A reason many people invest in index funds is to reduce some risks. They don’t want the risks that their manager is too heavily invested in a stock that goes bad, for example. But there are special risks of index investing. One of those risks is due to changes in the index or how it is calculated. Firms that construct indexes can make changes at any time in either the composition of the index or how it is designed.

Here’s an example. An index of preferred stocks changed how it calculates the yield-to-worst of the index. That’s the yield that would be earned if all the issuers of preferred stocks in the index bought back their securities as soon as they could. While the change had no immediate effect on the cash flow of investors, it significantly changed projections for the worst-case scenario.

A key measure of the exchange-traded fund’s yield plunged by nearly 3 percentage points on March 22. The change came because the index the fund tracks switched the way it calculates the metric known as yield to worst, which indicates the investor’s income from the fund in a worst-case-scenario.

The dropping yield underscores how investors in ETFs and other passive instruments, who are often looking to reduce the risk of high fees and bad stock or bond picks cutting into returns, can still be hurt by changes to their indexes. The PowerShares fund tracks an index of preferred shares that is managed by Bank of America Corp.

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