The following is the ninth of a series of weekly articles in which Sheryl will provide overviews of investment options that offer alternatives to bank accounts. Last week's article covered peer-to-peer lending. As with any investment that's not an insured deposit account, there are risks. Some may feel that these risks are worth it for the chance of higher yields. The focus of these articles will be on conservative investments that may appeal to some savers who want a chance of higher yields and minimal risk.
The battle royale in investing right now is active versus passive. While it seems like passive investing is about to claim victory, the bout isn’t over, and in the end it might just be a draw because there’s a place for both in most portfolios, it’s not necessarily an either/or proposition.
Passive investing simply means you invest without the help of an investment professional fastidiously watching and moving in and out of the market. An index fund is a passive investment. Simply put, it is designed to match the investment results of a specific market index, say like the S&P 500. It can be stocks, bonds, and have a variety of tactics to achieve returns in line with its chosen index. They are quite different from non-index funds, which seek to beat market returns, rather than maintain the status quo.
There’s no denying index funds are hot. Vanguard, the granddaddy of index funds is, now managing $3 trillion in assets. "Many people have lost confidence with the mutual fund industry. This view is confirmed by research of Standard & Poors which shows that between 58-73% of fund managers under-performed the index in the last year alone," says Shane Leonard CEO of Stockflare.com.
What’s the appeal of index funds? "You get wide diversification in a single package. Contrary to popular opinion, investors benefit from owning more stocks, not fewer," says Kyle O’Dell, owner of Secure Wealth Strategies. Including all the stocks in an asset class, such as a U.S. Small Cap index fund, is advantageous to shareholders. Studies show that owning more stocks will certainly reduce your level of risk, he adds.
"Index funds are ideal for any investor who relies on a dollar cost averaging approach to investing," says Anthony Alfidi, CEO of Alfidi Capital. Adding regular amounts to a small selection of the largest and cheapest index funds is an easy way to maximize the benefits of diversification over the long term.
"Diversification is the only free lunch when it comes to investing," says Mike Bayer, a certified financial planner with Burgeonvest Bick Securities Limited.
To put it in perspective, says Thomas Walsh, investment analyst with Palisades Hudson, "For as little as a $1, you could invest in an S&P 500 broad index fund and immediately own a piece of 500 different companies."
James Winkelmann, a registered fiduciary with Blue Ocean Portfolios, says that while index funds are not perfect, "they represent the optimal allocation tool."
Index funds, because they don’t have a manager continuously shuffling the portfolio, have lower costs than actively-managed funds. An index fund doesn’t need multiple managers to replicate an index, nor does it incur high trading costs due to its lower turnover. This allows many index funds to offer rock-bottom expense ratios, which have a material effect on long-term performance, says Walsh.
Furthermore, because an index fund has low turnover, it is very tax efficient when compared to an actively-managed mutual fund. Capital gains and losses are realized every time a stock is sold within a mutual fund, which are then passed to the investor as year-end capital gain distributions.
"It’s easy to choose index funds. Pick your asset class, then find the most efficient index fund that allows it," says O’Dell.
Look under the hood
But for all the merits of passive investing, "Not all index funds are the same. Look under the hood," says Paul Ruedi, CEO of Ruedi Wealth Management.
Investors need to understand the composition of the index they are buying. There are many different indices tracking everything form the broad U.S. stock market to highly specialized indices focused on leveraged loans. Understanding how the index is put together and the inherit advantages and disadvantages of each index strategy is very important. "Investors can buy different funds tracking the same area of the market and still end up with very different results," says Liam Timmons, president of Timmons Wealth Management.
Tracking error is key. It is how much the index fund’s returns vary from the underlying index. In some cases, the difference can be very large. Focusing on index funds with low tracking error is essential, explains Timmons.
While on the one hand, mirroring the market has advantages, what about when the market is in the basement? As the market goes, so goes your investments. For example, if the market is overvalued, buying a market capitalization weighted index (like a basic S&P 500 index fund), would mean buying larger weightings in the best performing areas of the market potentially increasing your risk. On the other hand, "Active managers have the ability to move money out of overvalued assets, hold cash, or even avoid entire areas of the market," points out Timmons.
Don’t get it twisted. Although generally index funds are considered low risk, during the peak of the tech bubble, the S&P 500 was comprised nearly 40% of technology stocks, says Joe Jennings, senior vice president of PNC Wealth Management. "At that point in time, the index was not well diversified and held its largest positions in some of the most expensive large cap stocks in the market. Understand what you own," he says.
What are your goals? "Some investors want the opportunity to outperform the index, at least with a portion of their investment portfolio," says Jennings.
Valuations change. Pure indexing focuses on owning everything regardless of value. "Though it removes the emotions and guesswork that often accompany attempts to fairly evaluate price, there are times when this can work against you," says O’Dell. For example, with pure indexing, even with the incredibly high valuations of the dot-com bubble in the 90s and the recent housing bubble, you would have kept pouring money into those sectors regardless of valuation. "This type of buying strategy within an index can really hurt the performance of the index," says O’Dell.
Jesse Mackey, chief investment officer of 4Thought Financial Group, argues that active investing has become more affordable than in the past. Through the emergence of managed accounts and lower-cost fee-based financial advisors, the ability of the average investor to access active strategies and approaches once only available to the wealthy and through hedge funds is now easier and more accessible, he says.
Back to why the battle royale might be a draw. Says Mackey,"The best investment approach is a mix of both passive and active strategies. This combined style can lead investors to a better risk return relationship in the long haul."