Almost all of the information you receive on this epic battle suggests that it will rage on for years with no apparent winner. And, ironically, almost every financial writer who stages this event always comes down on the side of index funds. They cite important considerations like tax efficiency and costs. But the real conversation isn’t about the fund itself, but how you utilize them and where.
Index funds are for the complacent, the investor who really trusts the ability of the index to do no trading throughout the year, sell the losers at the end of the year and buy the winners, and charge you next to nothing for the privilege.
There are essentially three things at play here. No trading throughout the year does in fact keep costs such as transaction fees to a minimum – at least quarter over quarter and because there are no trades, there are no tax implications. There are dividends paid and taxed as such which are offset by the selling of losers as the fund rebalances. Which is why it seems as though the fund is tax efficient – it generate fewer profits than an actively managed funds might do.
That selling the losers to buy the winners makes little sense. Granted, the key selling point in an index fund is trust. Trust that index will poke along on average for years, even decades and you will not have to do a thing. But each time the fund rebalances, it panders to the marketplace created by the active investor and the actively managed funds. Is it just me or does that make no sense. An index fund essentially waits for the market movers to give a stock new meaning – in other words they do the legwork, do the research and do the positioning so an index can come along and agree.
There are low costs. But people approach those costs from the wrong direction. Leaving an index fund in your retirement account, a tax-deferred situation simply doesn’t make sense. If the index fund is so tax efficient, why not pay the taxes now, as you go, in the relatively tax-friendly environment we are in.
Most comparisons to index funds, which are all created equal, are compared to the actively managed mutual fund, which are not. In fact, the comparisons are often so unfair as to be a mote point. When the comparisons are made, the whole of the actively managed world is grouped together – small caps, mid-caps and large-caps, funds that hold as few as 20 stocks to those that chase value and growth, and specific sector offerings.
Indexers will suggest that you have a one in three chance of picking a hot fund. But who wants a hot fund knowing that the fund’s “hot-ness” is the result of either investor enthusiasm or the fund manager’s prowess.
Indexers also sell their idea based on the assumption that you do not have the time to keep track of your investments. (Really? You just send thousands of dollars to a fund without regard, year-over-year, for decades!)
But why chose one over the other when you should be using both. Inside a retirement plan such as 401(k), you should seriously consider the potential of the actively managed fund, contribute at least 10% of your pre-tax income to a selection of four to five funds in different sectors, and stay invested. Most defined contribution plans have a limited amount of choices so this shouldn’t be all the difficult to achieve.
Once that is done, invest in an index fund – outside of your retirement account in a Roth, pay the taxes and hedge your bet against the future tax environment of retirement.
While most arguments will always point to how much more you could have made in an index fund based on the lower fees disregards the possibility that you might just make up that difference in performance. The last decade was not good for any investor. But I would much rather have a nimble fund manager who is looking for the next best opportunity rather than one who does nothing more than wait for the rebalance.
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