Sunday, August 16, 2009

Mutual Funds Explained: The Index Fund Argument

This argument is getting tedious. I goes something like this: Index funds have outperformed actively managed funds about 75% of the time. Those that cite that tedious fact, suggest that the next logical step an investor can make is to invest in index funds. Not so fast.

I have heard this index fund argument so often that I am concerned some folks may think that this is how to build wealth - at least enough for retirement. It's not.

Retirement accounts need actively managed funds to succeed. These types of accounts are tax-deferred (meaning that the taxes you would have paid on any growth are not paid until you begin drawing on the account and to continue the theory just a little further, you pay them when your tax bracket is lower). This is my primary argument for why retirement accounts should not have index funds in them. Index funds are simply too tax efficient.

Actively managed funds, provided you invest in the least expensive, the funds that beat their peer group - not some index - and offer a broad market style belong where risk is spread out over a long period of time. The problem with indexers, those who believe that the low fees are worth the low risk, is a need to embrace the set-it-and-forget-it style of investing. Could they just be lazy?

This belief - that index funds are better - can be blamed on the actively managed funds themselves. They have used indexes, often the wrong ones, to compare their performance. Side by side, this just doesn't work. No actively managed fund can offer 500 companies in its portfolio at any one time. Their goal is to pick the best from a group and run with it. They become investors, just like us only with far more market savvy than the guy sitting at his laptop in the coffee shop.

Actively managed mutual funds need monitoring in part because it is investing - not saving. With a good basket of actively managed funds, you can better diversify your risk and still avoid investment overlap (which, if one of your funds is an index fund, you are doing).

Keep actively managed mutual funds in a tax-deferred account. Keep index funds on the outside of these accounts and pay the taxes on any gains you have made (the tax on long-term capital gains is still low enough to make this an attractive strategy).

Investing is risk management. Remove the risk and you will pay with far less long-term reward.

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