Reader Q: Index vs. Active Funds

Reader: One question I wanted to ask is about investment costs or "fees" that most mutual funds charge. Do you prefer market tracking or index funds with low costs or more actively traded funds that try to beat the market returns which typically have higher costs?
Answer: It’s clear that this reader has some investing experience. Although most of our readers don’t share this investors level of experience, it is a terrific question for those of you working on the “next step” of retirement planning.

Answer: The “index funds” that the reader is referencing are mutual funds specifically designed to mirror the stock market updates that you see on the news and hear on the radio. For example, you might hear that the S&P 500 is up 1% today (it isn’t). The S&P 500 is a market index that samples 500 large cap American stocks (big companies like Coca-Cola, Google, and Ford). An index fund is a mutual fund that is a balanced reflection of that index, so that if the S&P 500 is up 1%, so are you. The quick advantages of these funds are that they offer low “margins” (fees) and a stable return on investment. Vanguard is a major company who built an empire based primarily on allowing average Joe’s like you and me to invest in index funds at razor-thin expenses. The disadvantage is that they are limited in their scope. Let’s say the auto industry is on the verge of a comeback, sales are up and they’re hiring like crazy. Wouldn’t you want to disproportionally weight your portfolio to take advantage of the success of America’s oldest companies?

Actively managed mutual funds often have much broader parameters as to where your investment goes: growth vs. value, small cap vs. large cap, etc... These funds are free to trade stocks and bonds around those broad categories. The advantage of these funds is that they can generally go anywhere to make money. If the gold bubble, tech bubble, or housing bubble is about to burst, they can get out. However, actively managed funds require significantly more research and “know-how” on the part of the fund manager, so they usually require higher fees, sometimes called “loads” or “expense ratios.”

Now for the answer to the reader’s question: it should be noted that as long as you’re looking at a fund’s historical returns (at least 10% per year for 5-10 years) and making sure that the fees are low, you really can’t go wrong here. Speaking in generalities, actively managed funds out-perform index funds while the markets are up and under-perform while the markets are down. This is a higher-risk, higher return strategy that makes many investors uncomfortable. If you’d like an interesting article on this, ABC News reports on Morningstar’s research on this topic. The author, who’s admittedly biased toward index funds, concludes that actively traded funds are simply not worth the risk. Such a position is reasonable considering the overall value of index funds. However, the author also appears to be in his mid-to-late 40s and shouldn’t be reading a blog meant for 20-somethings. If you’re under 30 and have money in the markets, you’re way ahead of your peers and most financial blogs and reports aren’t considering the fact that you have so many years of investing ahead of you. The bottom line: you should be in higher-risk, higher-return funds, but this should change as you age.