February 18, 2014

Index Funds

Credit: Stuart Miles
An index fund is a mutual fund constructed to try to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500), Dow Jones Industrial Average (DJIA), NASDAQ, MSCI EAFE, or Barclay’s Capital Aggregate Bond Index. This type of fund is very attractive to many people I meet. “Indexing” is a passive management investment strategy and it has, at times, outperformed actively managed investment strategies. There are aspects of index funds that I like, and aspects that I do not. Playing devil’s advocate, let’s see whether index funds are for you.

Index funds provide a good way to make sure your assets are at least somewhat diversified, and with any luck, you should roughly experience gains (and losses) similar to those other investors and companies in the same indexes experience. Index fund investors usually believe that markets incorporate and reflect all information at all times, rendering specific “security picking” futile. Therefore, index fund proponents argue the best investing strategy is to simply invest in index funds. This passive strategy usually results in less buying and selling of positions (which means fewer transaction fees and potentially less-frequent, realized capital gains). Index funds also require fewer resources to oversee, which means they usually have pretty low investment management fees. Keeping up with a particular index, paying fewer transaction fees, potentially paying less in taxes (in amount and/or frequency), and having to pay less in investment management fees sounds pretty darn good, doesn’t it?

People who decide not to go with index funds or are against “indexing” may have a wide variety of reasons. At a very basic level, it could probably be said that people invested solely in index funds are just trying to “keep up with the Joneses.” They want to make the same investment return as their next door neighbors. This is not an acceptable investment strategy for many people. It’s true that if you don’t invest in index funds, you might generate returns less than the index (or even losses when the index has gains), but you could also beat the index and do better than the Joneses! In order to have this shot, you have to do something different than the index and pursue a more actively managed investment strategy. When proponents of passive index fund investments hear the words “active management,” they may quickly cite the lower fees and taxes usually associated with index funds, but active management supporters like to remind index fund investors that if they pay any fees or expenses at all and are only invested in the index, they are actually agreeing up-front to accept a return less than the index every single time!

Most investors seem to go back and forth on whether they like passively managed index funds or not. It seems that when most index funds have recently outperformed their actively managed, competitive funds, they have lots of fans, but when they lag active funds, their support seems to dissipate. I’m like everyone else: I’d love to have owned what has recently done the best and to currently own what is about to do the best, but as always, the super short-term investment crystal ball is in the shop!

What? Oh, you’re going to force me to choose? Look, I respect and understand people who swear by index funds, but I’m personally not a huge fan. I think having some index funds as part of your portfolio is certainly reasonable and it could even be a good idea, but I could not solely invest in them. I don’t want to keep up with the Joneses, I want to pass by the Joneses and move to another neighborhood! It comes down to two things for me: 1) I believe there is almost always a part of every index that I don’t want to invest in, and if I “index,” I can’t avoid that piece, and 2) as a very simple and not-so-technically-versed client of mine told me after we discussed index funds, “I prefer actively managed funds because I know there is at least someone at the wheel as opposed to my investments being on auto-pilot.”


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