Index Funds: A Simpler, Cheaper Way to Invest

I'm conflicted about whether I should invest in actively managed funds or index funds. Ideally, I'd prefer to keep things as simple and straightforward as possible. -- Rusty, Albuquerque, N.M.

If you're looking to keep things as uncomplicated and trouble free as possible -- a perfectly reasonable goal, especially in these topsy turvy times -- I don't think there's any doubt that index funds are the better choice.

In fact, even if simplicity isn't an overriding concern, I still think you should consider keeping all, or at least most, of your savings in index funds that give you broad diversified exposure to the financial markets, or their ETF counterparts.

Why? Four reasons.

1. Greater certainty. One of the most valuable features about index funds is that you know exactly what you're getting when you invest in one.

Want large-cap stocks? Fine, put your money in a Standard & Poor's 500 index fund. Small caps? No problem, get a fund that tracks the Russell 2000 index or a similar benchmark for small companies.

Or you can make things really simple and invest in a total U.S. stock market index fund, in which case you get all U.S. stocks -- large, small, value, growth, all industries -- in a single fund. Throw in a total international stock index and a total U.S. bond market index fund, and you've got a fully diversified portfolio with just three funds.

You can build a portfolio using actively managed funds, but it requires more initial work and ongoing vigilance. The reason is that while you can get an idea of how an actively managed fund will invest based on its prospectus and its Morningstar category, the fund manager has wide leeway to stray from its specified strategy. And many often do.

During the go-go '90s, for example, it wasn't uncommon for value funds to juice their returns with growth-oriented tech stocks. To see if an actively managed fund has had a tendency to deviate from its stated investing style in recent years, you can plug its ticker symbol into the Quote box at the top of every Morningstar page and then click on the Portfolio tab.

So if you're looking to build a portfolio that you can be sure will have specific types of stocks and bonds in specific proportions, you'll have a much easier time doing so with index funds.

2. Lower costs. If keeping expenses down is a priority for you -- and it should be -- index funds are the hands down winner.

You can expect to pay roughly 1.5% or so a year on average for the typical stock fund and perhaps 0.75% or so for a bond fund. Index funds, by contrast, typically charge 0.25% to 0.5% a year, and by going to our Money 50 list of recommended funds you can find some that charge as little as 0.05%, or just $5 for each $10,000 invested.

To be fair, you can also find actively managed funds with fees considerably below the average. But you're not going to find any with the razor-thin fees of index funds.

Shelling out less in costs is a huge advantage, as every dollar of expenses is one less dollar of gross return that goes to you.

Over time, giving away more to fees can make a big difference. For example, if you invest $25,000 in two funds that both earn 7% annually before expenses and charge 1.5% a year and 0.25% respectively, after 20 years the fund with the lower fee tab will have an extra $19,000 or so.

3. Higher tax efficiency. In an attempt to deliver loftier gains to shareholders, many actively managed fund managers buy and sell shares frequently, hoping to rack up a profit or avoid a loss on each trade.

Even if that trading is successful after the costs it imposes, it can generate realized gains, which must be passed on to fund shareholders who must in turn pay taxes on them (assuming the fund is held in a taxable account).

If those gains are on shares held a year or less, they're taxed at short-term capital gains rates, which today are taxed at a top rate of 35% versus a max of 15% for long-term capital gains.

Since index funds track a specific benchmark, such as the S&P 500 or Russell 2000, their selling is largely limited to getting rid of securities that leave the index or providing cash to redeeming shareholders, and even in those cases there are techniques managers can use to limit taxable gains.

The result is that index funds generate far fewer taxable realized gains.By deciding how long you'll hold onto shares, you have more control over when you're taxed and what rate you pay. If you want to compare the tax-efficiency of an index fund to an actively managed fund, check out the Tax tab on each fund's Morningstar page.

4. Superior performance. If the three reasons I've already mentioned aren't enough to bring you into the index camp, then this fourth one probably will: Over long periods, index funds tend to deliver higher returns than comparable actively managed funds.

Indeed, over the past 10 years, large-company index funds that track the S&P 500 or a similar index and small company index funds that mimic the Russell 2000 or other small-cap benchmark have beaten the average gain for comparable actively managed funds.

That said, over shorter spans it's not uncommon for actively managed funds to post higher gains. And even over long periods, you'll always be able to find some actively managed funds that due to the extraordinary skill of their managers or plain old luck have outgained index funds, although identifying such funds in advance is exceedingly difficult if not impossible.

The point, though, is that index funds' lower fees and the fact their managers aren't constantly buying and selling make it more likely that, on average, they'll win out over actively managed funds in the long term.

Now, having made this case for index funds, I'd add that I don't think you have to be such a purist that you sink every single cent you have into index portfolios. If you're inclined to invest a portion of your money with a few managers who have solid long-term records and reasonable expenses, I don't think you would jeopardize your financial future.

But if you want to keep things simple and straightforward and you want to increase your chances of earning competitive returns that will build your wealth over the long-term, I think your best shot is to create a diversified portfolio using broad-based index funds or ETFs as your building blocks.

Index Funds: A Simpler, Cheaper Way to Invest

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