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Is an Index Fund Ideal for You?


Is an Index Fund Ideal for You?

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."

because an index fund has low turnover, it is very tax efficient when compared to an actively-managed mutual fund

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.

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

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."

Editor's Note: To learn more about index fund investing, please refer to the following resources: Bogleheads investment philosophy and Clark's Investment Guide.

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Comments
Anonymous
Anonymous   |     |   Comment #1
These are FDIC insured, of course...not. This article would have been great advice several YEARS ago before this bull market ran up to all-time highs. Individual investors always get in at the end thinking they missed something.
Anonymous
Anonymous   |     |   Comment #2
There is still money to be made, but it depends on your time table. If you are short term, sure keep all your money in deposit accounts, but if you are saving for retirement or any other long term goals, index funds are great. I had money in the 2008/9 crash, it was just a great time to buy low.
Anonymous
Anonymous   |     |   Comment #6
The question is whether or not this is a good time to buy. I'm always amazed when I hear it doesn't matter when you buy a stock. Well, it does or EVERYONE would be on the winning side of every trade and, for some strange reason, that does not happen.  
Anonymous
Anonymous   |     |   Comment #7
It does matter when you buy if you are buying individual stocks, or if you are only looking at a short time frame of a couple of years (and then you are right, now may not be a good time to buy). Long term investing, it really doesn't matter when you enter. Start earning dividends now and keep cost averaging. We aren't talking about a one time investment, but with long term investing you are going to keep investing monthly so in the long run, no it really does not matter, it will all even out. Plus, in 20 years if history is any example, the market will be even higher in 20 years.
Anonymous
Anonymous   |     |   Comment #9
Of course it matters. Studies have shown what happens when people retire at the beginning of bull and bear markets. Guess which retiree gets worried real fast. That's right, the guy who retired at the beginning of a bear market and is not only drawing down assets but losing value to market forces.
See http://theinsuranceproblog.com/why-life-insurance-works-so-well-for-retirement-income/

I'm so sick of hearing the mantra "long term" when it matters a great deal when you BEGIN that long term. Sure, if your timeline is 40 years you probably have enough time to weather some fairly bad times, assuming you make excellent decisions along the way. Retirees looking at 20 years of withdrawals simply don't have enough time to recover from serious declines. There's a reason the pros buy "when there's blood in the streets." 
Anonymous
Anonymous   |     |   Comment #10
Do the math of cost averaging. As I said, I took a major hit in 2009 (and 2000 for that matter). Bought low, and recovered everything in a couple of years. Even if there is a 10% dip this year, you'll recover it with time and cost averaging. 
Anonymous
Anonymous   |     |   Comment #3
Investing in the equities market, at this moment, brings up a set of caveats.  Look at a chart of NYSE and S&P Margin Debt, it is at an all time high.  Previous highs were March 2000, before the dot com bust, and July 2007, before the housing collapse.  Margin debt represents the amount of option trading, and leveraged debt, in the market.  Options are a contract to buy or sell equities at a future date and price, they are the domain of hedge funds of the wealthy.  The feds low rates allow hedge funds to borrow capital, and place options on future market movements.  Trades are done with virtual money, but profits are taken in real assets.  This bleeds actual market value, from long term investors, each time the indexes rocket up and down.  The longer the fed keeps rates low, margin traders push debt to higher levels, with less liquidity.  If the fed raises rates, at some point, the cost of borrowing short term money outweighs the risk involved in futures transactions, and hedge funds reduce their leverage.  
Anonymous
Anonymous   |     |   Comment #4
So how does this affect long term index fund investing?
Anthony J. Alfidi
Anthony J. Alfidi   |     |   Comment #5
Thank you for quoting me on index funds.  The good points of index investing include low annual management fees, no up-front sales loads charged in a brokerage account, high liquidity, and total transparency of holdings (at least for those funds based on widely known indexes).  The disadvantages are the same for any other brokerage investment. Index funds can lose money and their valuations are not guaranteed by any government agency or private insurer.
Anonymous
Anonymous   |     |   Comment #8
VTI and VOO are the index funds I invest in, don't forget the stock market is manipulated and it's manipulated to go up not down.... just ask the federal reserve.
Hannah Colvin
Hannah Colvin (anonymous)   |     |   Comment #12
Very useful information for the beginner investor. My brother has been investing in the index funds since some time now and these were exactly the questions he faced as a beginner investor. Knowing the trials and tribulations of the index investments, he decided to take help from international funds management professionals who had good knowledge about the index investments. Therefore, he did not face much trouble. But for people who do not have the guidance of good fund managers this post can really help a lot.