Index Funds - Are they right for you?by Gabriel ... is an ... approach that seeks to match ... returns of a stock or bond index. An ... tries to ... the
Index Funds - Are they right for you? by Gabriel Nijmeh
Indexing is an investment approach that seeks to match the investment returns of a stock or bond index. An investment manager tries to duplicate the target index by holding all the securities in the index. This is what is called a passive management approach which emphasizes broad diversification and low portfolio turnover.
There are a variety of indexes to suit each investment style. The largest and well known index is the S&P 500. This index is dominated by the largest blue chip companies and accounts for close to 75% of the U.S. stock market value. Other indexes include the Nasdaq, Wilshire 5000 Total Market Index, S&P MidCap 400, Morgan Stanley Capital International Europe, Australasia, Far East (MSCUI EAFE) and various bond indexes.
Since 1926, the stock market has an average rate of return of 11.3%. Investors have earned more or less depending on the type of investments and risks taken. It is very important to note that this return is before costs have been factored. Therefore, those investing in actively managed mutual funds may have a net return lower due to these costs and thus will earn significantly less than the market average.
These costs include:
- Management expense ratio (including advisory fees, distribution charges and operating expenses)
- Transaction costs (brokerage and other trading costs)
Index fund expense ratios are typically 1 percent and usually even less, compared with 1.5 to 3 percent for actively managed funds. Fund expenses and transaction costs for a typical mutual fund can take a big bite out of your net investment returns. Add sales commissions to your purchases and even more of your returns are swallowed. Typically, index funds can be purchased on a no- load basis thus saving you sales charges.
Of course, there is always a caveat... during periods of market decline, index funds can be expected to suffer somewhat larger declines over actively managed funds. A fund manager can make adjustments in anticipation of market declines by selling stocks and also has the option of holding a cash reserve. This is not something that occurs within an index fund because you are fully invested in the market and potentially corrective actions are not taken. Accordingly they may be regarded as a riskier option for some investors during market declines.
It can also be argued that when you invest in an actively managed mutual fund, you are paying a professional to research and pick winning stocks. You are not paying them 2 or 3 percent a year to park your holdings in cash. If that were the case, you would be better off putting your money in your savings account. It really depends on market conditions and the fund's investment philosophy and how it matches with your investment goals.
Another common thought is why shoot for an average return when you can try and beat the market. Well, it is very difficult even for seasoned money managers to consistently beat the index year over year.
Taxes are another aspect of investing that needs to be considered carefully. Every time an active fund manager sells a profitable stock, a taxable capital gain is triggered. Anytime some of an investment is taxed away, the magic of compounding is compromised. Index funds on the other hand are considered tax efficient investments because very few stocks are bought and sold and therefore few capital gains are distributed to investors. You choose when to sell your investments and therefore have a bit more control over the tax consequences. Index investing was once only available to institutional investors who take tax deferral seriously.
Indexing is a strategy that can be applied in many different ways. It is an efficient and low cost way to investment across various markets and asset classes. You can build a core holding of index funds and add a well managed mutual fund that enhances your portfolio's return.
What appeals to me about indexing is that I can have a broad basket of stocks that moves lockstep with the market so at the very least I am guaranteed a market return. In addition, I can purchase individual stocks or other mutual funds that will add value and enhance my overall rate of return.
Do index funds fit in your portfolio? This is something you need to determine based on your investment goals and philosophy. Over the long term index funds should provide competitive returns relative to actively managed mutual funds while keeping your costs down.
Gabriel is the editor and webmaster of The Money Advisor - http://www.the-money-advisor.com. He believes that everyone is capable of controlling their financial destiny with the right combination of rich thinking and smart action. The Money Advisor, a knowledge network of people, articles, tips, e-books and ideas about making money, saving money and building wealth!