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Personal Finance

Deconstructing Index Funds

By Hal Ratner
401k Forum's Director of Mutual Fund Analysis

So what's all this fuss about index funds?

After all, the best they can hope to do is return the market average. Come to think of it, that's the worst they can expect to do, too.

And that's precisely what the fuss is about: index funds are attracting increasing numbers of investors who feel that the relative certainty these funds provide is worth more than the chance to beat a benchmark now and then with a managed fund.

In fact, of all the mutual funds out there, index funds provide the highest probability that investors will meet the retirement goals they set using asset allocation tools.

Index funds buy and hold shares in the indexes we hear so much about ­ the S&P 500 (large-cap), Russell 2000 (small-cap) and Lehman Brothers Aggregate (bonds), for example. The performance of each index fund is basically identical to the performance of the index it represents, because it holds shares that mirror or reproduce that index.

When you invest in an index fund, what you see is what you get. Your return will reflect the market average, no more and no less. For some investors that is enough, while others may want to have index funds as their core investment while also dabbling in some actively managed funds to try to boost their returns.

Whatever category you fall in, here are some points to keep in mind about index funds.

Index funds provide the greatest probability that you will end up with your desired account balance at retirement, based on your asset allocation model. You probably won't have much less than you planned, and you probably won't have much more. This is because most asset allocation models calculate your saving and investing schedule based on the performances of indexes. With actively managed funds, managers sometimes stray from what the fund is supposed to be investing in (its "style"), in an effort to beat the benchmark. This can throw you off your investment track.

Since index funds operate by buying and holding shares, rather than by having a manager buy and sell shares daily in an effort to beat the market, their fees are comparatively low. Beware of an index fund with high fees.

In fact, according to one estimate (www.morningstar.net), over 30 years an investor in a low-cost index fund would have a 41% higher return than an investor in an actively managed fund (charging a 1.4% fee) because of the difference in fees.

Over time, very few actively managed funds outperform index funds. This is because of the higher fees and the "return to the mean phenomenon." (An actively managed fund that is performing better than the index will move toward the index as it attracts more assets. Unfortunately for the investor, the fees will probably not be reduced to reflect the change in performance.)

  • Index funds are representative of the stock or bond indexes that fund managers are trying to beat (the benchmark). Index funds cannot beat the benchmark because they ARE the benchmark. Similarly, they cannot fall below the benchmark. Actively managed funds can, and probably will, do both over the course of time. So if you prefer less fluctuation in your investments compared to actively managed funds, an index fund could be a good idea. Index funds do fluctuate, but only as much as the market does.

  • This does not mean that you should invest only in index funds. Well-run actively managed funds can give your returns a boost, especially if you have a long time to go before you retire. But you still might want to consider keeping some core holdings in index funds.

  • If you are lobbying for your company to include an index plan in your 401(k), you may want to present the following arguments:

    1. Including an index fund in a 401(k) plan will alleviate some fiduciary concerns of the plan sponsor, because index funds provide a higher probability that investors will meet their retirement goals.

    2. In almost all cases, index funds have outperformed managed funds over time.

    3. Index funds provide a degree of certainty in an investment portfolio, which to many investors is more important than the possibility of great performance but also more risk. Human Resources departments don't always take this into account when choosing a company's 401(k) plan options, perhaps assuming that everyone wants to beat the averages.

    4. Index funds are good core holdings because of their stable performance, relative to actively managed funds.

    5. Index funds have lower fees and may suffer less from market downturns than actively managed funds.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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