Index Funds: Not an Option if it is Mandatory

The wide world of investing is still so little understood by so many people, the government feels as though they need to step in a make the easy easier, the cheap, cheaper, and the option of choosing, no longer an option. Of course I speaking about the recent efforts to declare passive investing (index funds) the winner for all investors, knowledgeable or otherwise, over actively managed funds.

Do Fees Matter If They Are Cheap?
At the heart of every index funds are best argument is the cost. In the land of I don't want to take any risks anymore, passively managed mutual funds have been touted as the way out. More importantly, because the risk is mostly removed from these funds, the cost is as well.

But it is balance that has to be struck. How much risk is worth paying for? Or how much is no risk worth?

Index funds have always been the cheaper option. They trade less, adjusting the fund when needed, often as little as once a year when the index it attempts to mimic changes. This passivity creates fewer fees with the exception of 12b-1 fees, used to attract investors.

Actively managed funds are managed, traded more frequently and can, if done correctly, allow you greater gains for your investment. Comparisons are what is most difficult. Actively managed funds are compared to indexes and when this happens, investors suggest, why both with fees if I can get the same results from an index fund.

Since Vanguard Group pioneered the index fund, the field has become crowded with imitators looking to cash in on what John Bogle saw as the only way to diversify. The idea of the index has been revamped (some fund families employ different types of indexes based on dividend payments, different types of weighting, etc.) and with it, the costs and fees. In most cases, the buyer should be conscious of these subtleties and understand that the more effort that is put into the fund, the more costlier it will be.

Exchange Traded Funds have also entered the fray, claiming that they too are index funds that can be traded as needed. In other words, you become the active manager, paying the fees, doing the research, pulling the trigger on the trade. You incur the costs that were otherwise the fund family's responsibility. ETFs have gotten more sector specific and because of that, the risks have increased significantly. Plus, ETFs are also susceptible to style drift and in some cases, end up looking like a mid-cap fund.

But they should not be made mandatory inside a retirement account for two reasons. First, they are too tax efficient. When you are deferring taxes, it is best to have least tax efficient investment in those types of funds. Secondly, index funds move slowly through good times and suffer just like the average investor does during bad times. This lack of risk and flexibility could put the average retirement age far off into the distant future, further along than most would have anticipated. And that will give the illusion that your money was safer, when in fact yo simply put more in, receieved less in returns and waited longer to tap what you have earned.