When Index Funds Fail

Quick definition: Situations where index funds underperform, create poor returns, or shouldn't be the tool of choice—typically involving small markets with thin liquidity, concentrated portfolios, or niche sectors where the index methodology breaks down.

Key Takeaways

• Index funds work brilliantly in large, liquid markets like the U.S. stock market, but struggle in smaller markets, foreign equities, and emerging markets where liquidity and transparency are limited
• An index fund's performance depends entirely on the quality of the underlying index; a poorly constructed index will produce a poorly constructed fund regardless of the manager's skill
• The higher the concentration of an index, the less diversification you actually receive; a "diversified index" that's actually 30% in one stock offers no real diversification benefit
• Historical indices can experience significant structural breaks when market conditions change, meaning past index returns don't guarantee future performance
• Index funds can fail through liquidity events, where a fund's need to sell holdings to meet redemptions creates forced selling at inopportune prices

The Liquidity Problem

Index funds work beautifully when the underlying market is liquid and transparent. In the U.S. stock market—with thousands of publicly traded companies, millions of shares trading daily, and efficient price discovery—an index fund can track the index with minimal tracking error.

This breaks down in smaller markets and foreign markets. Consider an emerging market like Vietnam. There are fewer listed companies, less trading volume, and wider bid-ask spreads. When a Vietnam index fund needs to buy or sell a stock to rebalance, it might move the market. The fund might intend to buy 100,000 shares of a stock with a small float, but that order could represent a meaningful portion of the day's trading volume.

The same issue appears in U.S. small-cap and micro-cap indices. The Russell 2000, which tracks small-cap stocks, has hundreds of stocks with thin trading. A fund trying to track the index exactly faces the problem that buying or selling significant shares can move prices. The fund ends up with higher trading costs than you'd expect based on the stated bid-ask spreads.

Emerging market and small-cap index funds often use sampling—they don't hold all 1,000+ stocks in the index, they hold a representative sample. This is pragmatic, but it reduces the diversification benefit. An emerging market index fund holding 200 stocks out of 1,000 available is not fully diversified; it's a concentrated version of the market.

These aren't failures in a technical sense—the funds still track reasonably well. But the returns are materially worse than a comparable index fund in a liquid market. The U.S. large-cap index fund with 0.03% tracking error beats the Vietnam index fund with 0.50% tracking error, and the difference compounds over time.

The Index Quality Problem

The second major failure mode for index funds is a bad index. An index is just a methodology—a rule for deciding which stocks to include and how to weight them. If the methodology is poor, the fund will execute it perfectly and deliver poor results.

This problem primarily appears in specialized or factor-based indices. A "value index" that includes stocks with low price-to-earnings ratios sounds logical, but it depends on how the index is constructed. If the index uses a screwy valuation metric or weights it too heavily, it might systematically exclude genuinely cheap stocks or include ones that are cheap for a reason.

The more complex and specialized the index, the more room for a poorly constructed methodology. A broad S&P 500 index is straightforward—largest companies by market cap. A "dividend aristocrats" index requires more subjective decisions about what makes an aristocrat. A "low-volatility" index requires choosing how to measure volatility. A "climate-safe" index requires making contentious decisions about which companies are climate-friendly.

In these cases, an active manager who thinks carefully about what actually represents quality, value, or dividends might do better than an index fund that blindly follows a predetermined rule.

The problem is most acute when an index is new or follows a strategy that sounds better in marketing than in reality. A brand-new "emerging tech" index might gain a following and then systematically underperform because the underlying methodology is flawed. But by then, billions of dollars are tracking it and embedded in its poor returns.

The Concentration Problem

An index fund's value depends on its actual diversification. The S&P 500 index fund is well-diversified—no single stock is more than a few percent of the portfolio. But some indices are concentrated.

Consider a hypothetical "mega-cap tech index" that holds only the largest technology companies. By weight, it might be 50% Apple, Microsoft, and Nvidia. This is less diversified than the broad S&P 500, which spreads concentration across sectors. An investor buying the "mega-cap tech index" expecting diversification would be disappointed.

More problematic are specialized sector or geography indices. An "airline industry index" that holds only five major airlines offers minimal diversification—an industry-specific shock would devastate all holdings simultaneously. An investor thinking they're diversified by owning this index would be fooling themselves.

Index funds can only diversify as much as the underlying index allows. If the index is concentrated, the fund is concentrated, regardless of how well the fund manager does their job.

The Structural Break Problem

Historical index returns are based on past performance of the securities that were in the index at that time. But indices change—companies are added and removed, industries rise and fall, the composition of the index shifts.

An index's historical returns don't necessarily predict future returns if the index's composition changes fundamentally. The S&P 500 of 1980 was a very different portfolio than the S&P 500 of 2020. Technology was tiny; energy and finance were dominant. The index's historical returns reflect that composition.

Investors buying into the index today are betting on a very different portfolio. The index methodology is the same (largest companies), but the actual companies and sectors are different. There's no guarantee that an index of massive technology companies will match the historical returns of an index that was mostly industrial and financial companies.

This is a subtle problem because you're still buying the index as defined, but the index as defined means something very different today than it did historically. This matters particularly when evaluating specialized indices with short track records.

The Redemption Crisis Problem

In extreme market stress, index funds can face a dangerous situation: investors want to redeem (withdraw money), but the market is illiquid and the fund can't easily sell holdings to raise cash.

This happened partially during the COVID crash in March 2020, when some funds faced redemption pressure while trading was chaotic. It's happened in bonds and emerging markets several times. The worst case would be a massive index fund experiencing redemptions in a frozen market where it can't sell anything without taking severe losses.

Index funds rely on the assumption that they can always find buyers and sellers to implement their strategy. In a systemic market failure where trading dries up, even the best index fund becomes problematic.

For retail investors, this risk is minimal because major index funds operate in liquid markets. But for anyone owning an index fund in an illiquid asset class (emerging markets, bonds, commodities), this is a real risk.

The Cost Paradox

Here's an interesting failure mode: as index funds become cheaper and cheaper, they paradoxically become less attractive to some investors. With a zero-fee index fund available, why would you hold a 0.03% fund? The answer is that you probably wouldn't.

But this creates a problem for index fund operators. If all index funds race to zero fees, the funds become commodities with no competitive advantage. Firms can't profit from them, so they invest less in fund administration, tracking accuracy, and shareholder service.

We haven't reached this point with major index funds, because Vanguard, Fidelity, and other large operators still profit from the assets they manage. But if fees fall to true zero indefinitely, the long-term quality of index fund operations might deteriorate. The index fund might become free but poor quality.

When Active Management Actually Beats Indexing

There are genuine cases where careful active management outperforms the index. These are rarer than many active managers claim, but they exist:

Emerging markets: In less efficient markets with less transparency, a skilled active manager might identify mispricings that the market hasn't incorporated. This is harder in developed markets but more possible in emerging markets.

Illiquid asset classes: In bonds, real estate, and other illiquid assets, active management and careful trading can sometimes unlock returns unavailable to passive indexers. This is less true than it used to be, as passive alternatives have grown, but pockets remain.

Tax optimization: An active manager in a high-tax environment might use sophisticated tax strategies (loss harvesting, asset location, tax-loss swapping) to improve after-tax returns beyond what a passive index fund can achieve.

Niche strategies: In certain highly specific areas—small stocks, distressed securities, technical patterns—there might be persistent inefficiencies that an active manager can exploit.

The key is that these cases are exceptions, not rules. For the vast majority of investors in the most liquid markets, index funds dominate active management. The exceptions exist at the margins, and even then, you need a skilled manager to exploit them.

The Mermaid diagram showing when index funds work best:

The Bottom Line

Index funds fail primarily in three scenarios: (1) illiquid or small markets where tracking costs become substantial, (2) specialized or poorly-designed indices that don't actually achieve what investors expect, and (3) systemic market stress that makes trading impossible.

For the 80% of investors in liquid U.S. stock markets using broad indices, these failures are irrelevant. Index funds work brilliantly. But investors in niche strategies, emerging markets, or specialized sectors should evaluate whether the index they're tracking actually serves their needs and whether an active alternative might be more appropriate.

The fact that index funds can fail in edge cases doesn't diminish their success in core cases. It just means that indexing is the right answer for most investors in most situations, not for all investors in all situations.

Next

This concludes the chapter on how index funds work. You now understand the mechanics of tracking, rebalancing, tax efficiency, structural differences, and the economics of index fund operation.

In the next chapter, we shift our focus to the question of how index funds compare to their alternative—exchange-traded funds—and explore the specific advantages of ETFs over traditional index mutual funds.