13 reasons index mutual funds and ETFs rule

Reprinted courtesy of MarketWatch.com
Published: July 24, 2013
To read the original article click here

Two of Wall Street’s best inventions of the past half a century are the low-cost index mutual fund and its younger relative, the commission-free index exchange-traded fund, or ETF. But ironically, Wall Street hopes we won’t use them.

Index funds and ETFs give investors low-cost, tax-efficient access to many asset classes that once were available only through relatively pricey actively managed mutual funds.

That’s very good news for investors. But it’s bad news for Wall Street, because index funds don’t lend themselves to sales commissions, high management fees, high turnover of assets and the other sorts of things on which the investment industry thrives.

Here are 13 reasons I think index funds are your friends. Most of them apply to index ETFs as well, especially ETFs that can be purchased (as many can) commission-free.

  1. You get wide diversification in a single package. Contrary to much popular opinion, investors benefit from owning more stocks, not fewer. By including all the stocks in an asset class such as U.S. small-cap value, index funds give that advantage to their shareholders. Studies show that owning more stocks will probably increase your return, and it will certainly reduce your level of risk.
  2. Index funds have low operating expenses. An index fund has no need to pay a staff of analysts to travel the world looking for exceptional “deals” or to hover over computer screens trying to figure out the economy. Index funds sometimes charge only one-tenth as much as actively managed funds in the same asset class. Those savings go to shareholders.
  3. Index funds have low internal trading expenses, because they simply don’t trade very often. Portfolio turnover is often overlooked by mutual fund investors, but the combination of commissions and spreads (the difference between bid and ask to buy and sell stocks) can cost as much as a full percentage point per year on top of operating expenses.
  4. Because of their lower turnover, index funds reduce your tax exposure. Sometimes an actively managed fund can hit you with nasty, unexpected tax consequences. For example, a manager may sell a position in a stock the fund has owned for years, leaving shareholders with a large capital gain. In a taxable account, you are liable for your share of that tax even if you owned the fund for only a week.
  5. Index funds give you control of your exposure to the specific asset classes you want. In an actively managed fund, there is always the risk that a manager will acquire stocks that may seem attractive even though they don’t fit the fund’s intentions. Index funds also eliminate the risk of duplication, which can leave you owning several funds that all own the same stocks.
  6. When you buy an index fund, you know what you’re getting – the performance of an index. The index fund manager’s job isn’t to scour the world for good stock picks but simply to mirror the index. An active manager cannot do anything that easy and simple; he or she must do something different, and hope that it’s better than the index. Unfortunately for shareholders, very often, the opposite is true.
  7. You will most likely get above-average returns. Of course there is no guarantee, but if you buy an index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class. That’s very good. In fact, it’s great!
  8. You won’t have to worry about monitoring the performance of an index fund manager. The manager’s only stock-picking role is strictly mechanical, to mirror what’s in the index. This is simple and inexpensive. And it’s very easy to compare your performance with that of its index; they should be extremely close.
  9. Index funds are easy to rebalance on schedule without worrying whether, by selling, you will miss out on a manager’s “hot streak.”
  10. Index funds are good for one-decision investors. Once you have found index funds in the asset classes you want, you don’t have to do anything. The only exceptions are adding new money, withdrawing money, periodic rebalancing and occasionally changing the mix of your equity and bond exposure.
  11. Index funds don’t keep your money idle in cash. It is not uncommon for actively managed funds to keep 2% to 10% of their portfolios in cash. One reason is to preserve buying power to purchase “hot” stocks; another is to cover redemptions of shareholders who want to bail out after market declines. That cash can cost shareholders 0.5% a year in return, with no corresponding benefit. This doesn’t happen in index funds.
  12. It’s easy to choose index funds. Pick your asset class, then find the most efficient index fund that follows it. If you’re choosing actively managed funds, each asset class may force you to choose among hundreds of funds whose management, track records and portfolios are constantly changing.
  13. Index funds put you in very good company. Index funds are favored by Nobel Prize winning economists, Warren Buffett, John Bogle, Charles Schwab, almost all academics, the largest U.S. pension funds, and almost every fiduciary adviser.

Choosing index funds is easy, and I’ve made it even easier for you. Check out my specific recommendations of asset classes, mutual funds and ETFs. To learn more about the advantages of index funds, listen to my recent podcast.

Richard Buck contributed to this article.

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