Disadvantages of a Large Cap Index Fund

Investing in a large-cap index fund can provide you with both benefits and disadvantages. In order to qualify as a large cap company, a company has to have at least $10 billion in market capitalization. There are a number of financial indices that are made up of large-cap stocks. A large-cap index fund is one that invests in every stock within a particular large-cap financial index. This amounts to a passive form of management because the fund managers simply have to mimic the financial index.

Arbitrage

With this type of investment, you have to worry about a certain amount of arbitrage. With financial indices, stocks are periodically added to and subtracted from the index. For example, when a company that was previously a large cap company falls into the category of mid-cap companies, then it will be removed from the financial index. When this happens, another company that was previously outside of the index will be included. When an announcement is made, all of the index funds that are tracking a particular index will buy up a large amount of shares of the available stock in the market.

When this happens, the price of the stock is going to increase. In some cases, mutual funds will try to accurately predict what stock is going to be added to a financial index and what stock will be subtracted from it. If they can get in and purchase the stock ahead of time, it has been found that they could make as much as 8 percent in the short term, just from the impending announcement. This introduces a guessing element to the investment and some mutual funds put money into the wrong stocks.

Expense Ratio

Another disadvantage of this type of investment is that you are going to have to pay an expense ratio. The expense ratio is the amount of money that the mutual fund company charges to cover operating expenses. This fee is used to pay for the salaries of the fund managers, administration costs and distribution costs. This is taken out of the earnings from the fund and it can negatively impact your investment overall.

Limited Returns

One of the downfalls of investing in this type of index fund is that you are going to have limited return possibilities. Anytime that you invest in a financial index, you are not going to be able to get as much as if you had subscribed to active management techniques. Active management techniques can sometimes beat out passive management techniques that only aim to mimic a financial index. By utilizing the talents of a knowledgeable fund manager, you can bring in a superior return on your investment over the long-term.

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