The concept seems so simple and smart: An investment that buys the market instead of trying to individually pick winning and losing stocks. By buying the market you are investing in the concept that people will continue to innovate and generate economic growth. It also overcomes many of the emotional behaviors that impede long-term investment success including excessive trading, becoming attached or too loyal to your specific holdings or just being wrong in your individual picks.
Without a doubt, index funds can be a powerful tool for growing your financial assets. They are also increasingly popular. Among households that own mutual funds, about a third had at least one equity index mutual fund in their portfolio in 2015, according to the Investment Company Institute. Here are some of the benefits of including index funds in your portfolio:
Low fees. Index funds cost far less to own than the average mutual fund. The asset-weighted expense ratio across all mutual funds was 0.61 percent in 2015, according to Morningstar's annual fee study. But you can often find index funds that cost far less. Many financial firms, including Vanguard, Fidelity and Charles Schwab, now compete to sell the lowest cost index funds. This has created an opportunity for investors to buy index funds with internal expenses as low as 0.03 percent per year. This low-cost structure is what gives index funds their strong performance.
Tax efficient. You might need to pay taxes on capital gains that are generated by trading activity within a fund. If your investment assets are held in a taxable account, this annual tax bill can have a negative impact on your long-term investment performance. A good measure of how much trading is occurring within mutual funds can be found by reviewing their turnover ratio. This data point will show you the percentage of the total portfolio that is traded in a year. Index funds do not have much turnover since investments are removed and added to market indices on a limited periodic schedule. This lack of trading creates the advantage of not generating as much taxable income as many active managers do when they make frequent trades.
No fund manager to pay. Many of the brokers who sell active management tout that their professional managers are worth the cost because they have strategies to beat the market. However, it is amazing how few active managers are able to consistently outperform the S&P 500. During the one-year period that ended June 30, 2016, over 80 percent of large-cap, mid-cap and small-cap managers underperformed their index benchmarks, according to a S&P Dow Jones Indices study. Even fewer managers are able to outperform the S&P 500 over a five or 10-year period. Index funds allow you to keep up with market growth. You probably won't beat market returns, but you also aren't paying for a fund manager who might lose money by selecting investments that decline in value.
With these strengths, why haven't index funds been adopted by more investors? A big driving factor is that many brokers are paid through commissions and thus do not have a way to get paid by recommending low-cost index funds. Since the primary providers of index funds are either direct-to-client providers like Vanguard or low-cost brokerage companies such as Fidelity or Charles Schwab, commissioned advisors have not been eager to adopt index funds. Without an incentive to sell these efficient products, they get bypassed in the brokers investment recommendations.
Ask your current advisor about his or her thoughts about index funds. A fee-only advisor should be able to help you build a low-cost portfolio and choose funds that are in your best interest. Do some additional research so that you can use your goals, risk profile and age to help craft the appropriate mix of diversified holdings. Index funds can help you keep costs down so more investment gains stay in your account.
Brian Preston and Bo Hanson are fee-only financial planners who host the podcast, "The Money-Guy Show".
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