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Are lower expenses the main benefits of index funds?

Jun 19, 2012 by Esther from Plymouth, MA in  |  Flag
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12 votes

Hi Esther, that's one of the key benefits. By some estimates, index fund costs can be 60-80% less than actively-managed mutual funds (where the fund manager is trying to beat the market).

But another benefit is tax efficiency. The component stocks inside an index fund typically don't change much during the year, which means there are typically fewer trades taking place inside an index fund. And that means fewer taxable distributions from an index fund, on average. That simply means you enjoy a more tax-efficient investment, because you may have much lower (or sometimes even zero) dividends or capital gain distributions from an index fund--again, in general. (Note that tax efficiency doesn't really affect your index fund holdings inside an IRA or a 401k, because those earnings are tax deferred already.)

Another benefit is transparency. With index funds, you have a very good idea of what the fund will hold, because the index its related to makes its holdings public knowledge.

So those are some of the benefits of index funds. I personally think they make an excellent choice for your retirement savings. Vanguard Funds, for instance, provides a great lineup of low-cost index funds, and they do a great job educating their investors. Mike

Comment   |  Flag   |  Jun 19, 2012 from Orland, IN

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10 votes

The above answers are definitely on target. Costs, including tax and trading, definitely favor index funds. They may not be glamorous but they provide you the highest odds of delivering performance over the long run.

Passively managed funds follow similar principles but may avoid a small downside of some index funds. When Wall Street can assess which stocks will replace and be removed from indexes, they will trade in advance which reduces the performance to the index fund owner. Passive fund managers, including Dimensional Fund Advisors (DFA) which must be purchased through an adviser, avoid this downside.

Not mentioned is a key question for those choosing funds actively managed (by stock and bond pickers as well as market timers): Is the investment manager's (superior) performance due to luck or skill? If it was skill, can you identify skillful managers in advance for the future? And, can you stick with a skillful manager when they hit a rough patch which could extend several years?

In my opinion, time is better spent on an investment plan (asset allocation) which fits well with your (1) resources (investments, income from work, etc.,) and which has reasonable return expectations
(2) spending needs (3) psychological ability to handle the periodic downturns in markets. If you are retired or retiring soon, a solid source of income which is not subject to the vagaries of the markets is important.

Hope this helps.

Comment   |  Flag   |  Jun 19, 2012 from Ridgefield, CT

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Hi Esther; Lower expenses are important, to be sure! Let's face it, most managers can't even match index returns, so one has to wonder what they're paying for, especially when predictable results are problematic, at best. But, I believe most advisors see index funds as components of a larger asset allocation picture in terms of weighting exposure to different parts of the market... and also as a way of helping insure 'purity', meaning reducing `style drift' - sometimes a 'large cap' manager may stray into another area hoping to enhance returns. When that happens, the allocation 'pie chart' you're looking at isn't necessarily the one you really have... and that changes the correlations, as well as the risk profile of the investor's portfolio.

Comment   |  Flag   |  Jun 19, 2012 from Moorpark, CA

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Yes, when investing in a mutual fund or ETF you can expect the return of that particular index minus the expenses. The total expenses for the average index fund is around .35 compared to 2.5-3% for the average actively managed fund. Just do the math!

Over five year periods about 25%-30% of actively managed funds outperform their comparative index. In another five years about 2% or so are still on top. Many academics attribute the small percentage of outperformers to luck. Now here where it gets interesting; After the initial; five year period around 20% of the top performers do not even exist anymore. Going forward It is just about impossible to identify the top performers and who the heck can predict which funds will be closed or melded into other funds?

Comment   |  Flag   |  Jun 19, 2012 from Cleveland, OH

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George Cones, JD Level 20

I would just like to add to Mr. Wilson's answer. There are index Exchange Traded Funds ETFs available as well. At Vanguard, ETF internal expense ratios are low even compared to the same mutual fund index funds. If you have a low-cost trading account, this may be a viable alternative.

Comment   |  Flag   |  Jun 19, 2012 from Wilmington, DE

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