Reasons Why I Like Index Funds
May 3, 2008 – 6:11 amIndex funds seek to track a financial index, and therefore do not require an active management team to make buy and sell decisions. Although matching the performance of an index does still require some overhead expenses, these expenses are typically much lower than those of an actively managed fund. Likewise as an index fund grows it’s invested assets, I would surmise it would not require as many additional managers and support staff as an actively managed fund (which might need more stock analysts, etc).
The benefits of index funds are numerous, but I’d like to discuss a few of the big ones for me today.
Rock-Bottom Expenses
All mutual funds have overhead expenses to handle everything from fund manager salaries to business and administrative expenses. Expense ratios are typically quoted as a percentage, like 1.1% for example, and they represent the cost of operating the fund. A fund might return 12% in a given year, but if the expense ration is 1.1% then your actual return would be 10.9%. You also need to be careful to understand how your source of returns deals with expenses. Some publications quote returns net of expenses (to ease comparisons), while others quote total returns before expenses.
Lower expenses mean more of your money is working and compounding, and over a long period of time can be worth a big chunk of change. Index funds typically have much lower expense ratios than comparable actively-managed funds. For example, Vanguards Total Stock Market Index Fund (VTSMX) has an expense ratio of 0.15%. The industry average expense ratio is 1.18% (Vanguard.com).
Low Turnover
Funds buy and sell securities based on the fund manager’s investing style and knowledge. Index funds track a pre-set list of securities, and therefore don’t have to buy and sell securities very often. This allows capital gains to accrue, and therefore the total tax impact is greatly reduced. This point about a fund’s tax efficiency is only important if you hold funds in a taxable account.
Easy To Implement Your Asset Allocation
The broad-market indexes provide a way to setup an easy to maintain asset allocation. A simple asset allocation consists of stocks, bonds, and cash. With Cash in a money market or CD you could implement your remaining investments with two separate index funds (or perhaps even on fund like Vanguard’s Balanced Index fund, which uses a 60/40 stock/bond split).
As your asset allocation gets more complicated you may need to add additional index funds for your additional categories. These categories might include: Large Company Stocks, Mid-size company stocks, small company stocks, REITs (real estate investment trusts), and International stocks. For the bond portion of your portfolio you could divide your funds across short and longer term bond index funds, US bonds and corporate bonds, municipals or inflation-adjusted bond index funds.
Regardless of whether your asset allocation had 3 buckets or 10, managing and tracking your asset allocation will be easy because each fund represents one specific type of investment. It’s therefore easy to know if your REIT investments are worth more or less than your targeted percentage at any point in time.
With actively managed funds you have to take additional steps to figure out what their internal asset allocation is, figure out if it’s changed since the last time you rebalanced your portfolio, and add up all of your funds’ components to figure out how much you actually have invested in “Large Cap” stocks for example.
Index Funds Are Fully Invested
Every dollar that is invested in an index fund already knows where it’s going to be invested. There’s no decision that needs to be made on investing now or later, which sector looks the most promising, when will the junior analysts out on the road get back to recommend new investment opportunities, etc.
By having a predetermined set of securities to invest in, index funds don’t need to keep a cash reserve for future investment opportunities. This means of my money is working in the market every day. If I wanted to keep cash on the sidelines I would put it in my own money market account, not pay a fund company 1% a year in expenses to “manage” my cash by putting it in a money market account!
Performance Performance Performance
Stock index funds typically outperform the majority of actively managed funds. I’m not going to discuss why this is the case in detail, but in the financial media it is frequently reported that index funds outperform actively managed funds 80% of the time (I wish I could find the original source for this). This is probably the case most often during time frames of 10 years or longer.
This is due partly to:
- Higher expenses, which an actively managed fund has to overcome just to reach the same starting point as an index fund. Actively-managed funds typically have expenses that are larger by 1% or more, which is a big disadvantage.
- Manager’s have trouble staying true to their investing style because investors may pour money into a fund one month and sell off like it’s the end of the world the next month. It’s hard to maintain long-term stock positions under these conditions.
- As I discussed before, index funds usually have a smaller portion of funds kept in cash. This means more dollars are invested and therefore are working harder in an index fund than they would be in an actively managed fund.
Instant Diversification
I’m not proposing that you should own just one fund, index or otherwise. Broad market-index funds, like the Total Stock Market Index Fund by Vanguard for example, provide a significant level of diversification that a single actively managed fund may not provide. Most fund managers have a predefined style that influences their investment decisions. They might be a value investor, or a growth investor, a small-cap investor or a mergers and acquisitions specialist. While these styles give a level of discipline to active managers (which is good), it’s common for investors to pick and choose numerous funds in order to get a little bit of each style. Here’s a novel idea: buy the whole market through an index fund! That way you’ll be getting a little bit of each style automatically, even styles you’re not even aware of!
Index Funds Let You Focus On The Things You Can Control
- Diversification through indexing means you take on “market risk” but not the specific risk associated with holding just a few securities
- Your money is (mostly) fully invested in the market
- You’re paying minimal expenses, which is a controllable expenditure
- You’re asset allocation is easy to setup, monitor, and maintain
- You don’t have to monitor your fund manager’s recent performance or career
- Minimal tax implications
- (Hopefully) most retirement plans offer at least one index fund option, which makes managing a portfolio spread across six different accounts at six different companies a little easier
- You’ll be above average in overall performance by simply trying to get market average returns
- Index funds are great core holdings, which is why most state pension funds using index funds for a large portion of their investments. You can still augment your core holdings with other investments based on your own goals and knowledge.
Please consider these benefits carefully, review your own portfolio, and make your own decision whether index funds are right for you!
If You Liked This Post Then Please Check These Out...
|
1 Trackback(s)