The joy of index funds

What's the better investment: an index fund or an actively managed fund? Walter Updegrave tells you where to put your money.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I'm interested in mutual funds as a long-term investment and have noticed that index funds tend to have much lower annual expenses than actively managed funds. So my question is why would I ever want to buy the more expensive actively managed funds? Don't index funds perform better after taking expenses into account? And if I'm sticking to index funds, am I better off in ETFs than regular index mutual funds? - John

Answer: You won't get any argument from me about the virtues of investing in mutual funds. Indeed, I consider myself one of indexing's biggest boosters. Like you, I'm a fan of index funds' razor-thin fees.

Many charge 0.2 percent a year or so, and some have expenses that are even lower, sometimes as low as 0.07 percent. That's a pittance compared with the 1 percent to 1.5 percent or more than most actively managed funds collect from investors.

There's no guarantee, of course, that a particular fund will outperform just because it has low fees. But whenever I've compared the performance of high-fee funds vs. that of low-fee funds over long periods, I've found that as a group the funds with lower charges typically do generate higher returns.

But there's plenty to rave about even beyond index funds' easy-on-the-wallet fees. Like certainty. Index funds slavishly follow an index or benchmark, so you always know what you're getting. You don't have to worry about your large-company fund manager poaching in small caps to juice his returns, or a value manager picking up a few growth stocks to boost performance when value stocks are on the outs.

Index funds' consistency makes them ideal building blocks for creating a diversified portfolio that contains all sizes of stocks, styles of investing and different types of bonds as well. As if that's not enough, index funds tend to be tax-efficient, which is a fancy way of saying they generally give up less of their gains to taxes.

Unlike actively managed funds whose trading can generate realized gains that must be passed on to shareholders and then taxed (assuming the fund isn't held in an IRA, 401(k) or other tax-advantaged account), index funds' buy-and-hold approach results in less trading and triggers fewer taxable distributions.

But as much as I love index funds - and think most people would improve their prospects by taking an index-funds-only approach - I'm not such a purist that I think you would be sabotaging your financial future by deciding to put a bit of your money into actively managed funds.

There are some managers who have special insights in some areas and have a chance to add value beyond what they charge in fees. Granted, I think it's a small minority of managers who can do this over long periods of time. I also think it's extremely difficult to identify those managers in advance. I can understand that some people want a shot at market-beating performance with a portion of their savings.

My advice, though, would be to keep that portion relatively small and make index funds your core holdings. If you do invest in actively managed funds, I'd also recommend that you stick with ones with relatively low expenses. And while past success certainly doesn't guarantee more of the same in the future, I'd still prefer managers with a solid record of achievement over a variety of different market cycles.

For actively managed funds worth a look, I suggest you go to our MONEY 70 list of recommended funds. Of course, we've also included index portfolios and ETFs on our list, and you can check out those offerings by clicking here and here.

As for exchange traded funds versus index funds, ETFs can have a small theoretical advantage as far as tax-efficiency is concerned because of the way shares are created and redeemed. (For more on the nuts and bolts of how they work, click here.)

I wouldn't make too much of this difference, though, especially since some of the big index funds are very good at using a variety of techniques to minimize their taxable distributions. One difference that really does matter is that you've got to buy ETFs through a broker and thus pay brokerage commissions. If you're dollar-cost averaging or investing small amounts of money, this can significantly increase the cost of investing in ETFs.

So unless you're investing a decent chunk of cash - say, $20,000 to $30,000 or more - you're probably better off just sticking to regular old index funds. The other thing you've got to be careful about with ETFs is that companies are churning out versions aimed at increasingly narrow niches of the market. Some, like the Emerging Cancer ETF (I kid you not), strike me more as marketing gimmicks than bona fide investment strategies.

Now, far be it from me to suggest that the purveyors of ETFs would want people to engage in speculation or rapid trading. Nonetheless, I think the temptation is there with many of these ETFs. And I recommend resisting that temptation, and using ETFs as buy-and-hold investments that can give you exposure to the broad market, or to specific areas of the market that you may need in order to build a more diverse portfolio.

Overall, though, I'd say I agree with your view of investing. Index funds, whether in their conventional form or ETFs, can be great low-cost ways to invest. And if you use them the right way - that is, to build wealth over the long term rather than for frequent trading or speculation - I think you can do just fine with either version. Top of page