Index Funds Losing Popularity?

The Wall Street Journal reports that E-Trade will be closing down all four of its index-linked mutual funds. E-Trade claims that the company is financially healthy, so this step may be a response to a reduction in investor demand in index funds.

Index funds seek to replicate market returns, instead of attempting to generate absolute returns. This means that unlike an actively-managed fund that aims to "beat the market" by picking winning stocks and to turn a profit whether or not the market is in a slump, an index fund's purpose is to match the market return, even when that return is negative. Investing through an index fund allows an investor to eliminate much microeconomic, company-level risk through the high level of diversification achieved by investing in an entire index of stocks rather than just a few stocks.

However, index funds are still subject to the macroeconomic risks that affect the entire economy like inflation and credit illiquidity. As the current economy continues to sink into recession, stock indicies are unlikely to see much growth in the near future, making index fund investing a losing strategy in the short run. Index fund investors may now be heading for the doors to gain short-term gains through actively-managed funds or to prevent further losses by retreating from the capital markets entirely. Either way, this trend may only last as long as the recession because once investor optimism returns (however long that takes), investors will likely once again see index funds as the best way to ride the wave of a rising economy.