Investing - Index Funds, ETFs, Advisors

Investing - Index Funds, ETFs, Advisors

Indexing vs Active Management for Mutual Funds

A quick definition - for an actively managed mutual fund, a manager or management team selects stocks or bonds to put in the fund. It is hoped that the stock selections will perform better than whatever index there might be for the chosen strategy. For an index fund, the choice of stocks or bonds matches an index such as the S&P 500 (and is kept in sync).

Typically, index funds trade assets less than active funds, have lower management fees, are very diversified, and aren't subject to management changes. The choice of assets in the index is subject to strategy and how they are chosen.

Choosing what index fund to invest in was once easy. Just find the lowest fee S&P 500 fund. No more. Now the question is - what segment of the market do you want to invest in. Big company, medium, small, growth, value, dividends, capital weighting or equal weighting, market segment (health, tech, utilities, ...), what part of the world.

I have always had a philosophical bias against indexed mutual funds. A corporation gets into an index by being successful. But it stays in the index by having a high stock value. And the stock value is enhanced by being purchased by index funds. So once a corporation is in an index, it stays in the index because it is in the index - index funds must buy it. I'm not saying that this is the sole support of the stock price, but it is a factor. And as index funds take over the market, it becomes a bigger factor.

Index funds trade very little. VFINF (Vanguard S&P 500 Index) lists turnover at 4%. Low turnover active fund are typically 25% to 50% (much higher for speculative funds). In addition to trading costs (which I would think are close to zero these days), this incurs taxes. Mutual funds must distribute capital gains and dividends every year, so with active funds in taxable accounts, you will be paying some of the taxes now instead of later.

But performance is what counts. I haven't tried to verify this statistic, but it is commonly reported that 80% of active funds underperform their benchmark index. So 20% of active funds equal or outperform their benchmark index. Can you choose a fund that will outperform? Yes. Will it continue to outperform long term? Maybe.

But performance isn't all that counts. If the funds are in an IRA or Roth IRA, taxes don't matter - yearly distributions and capital gains from sales are not taxed (but of course anything that you take out of an IRA is taxed as income). For tax un-advantaged accounts taxes are critical. Dividends are taxed and capital gains caused by turnover or selling to cover redemptions are taxed. You can't control this. In a down market, redemptions may cause big capital gains right when you can't handle them. If you don't need the distributions for income, you are paying taxes now instead of later. And if you need to sell the fund because of underperformance, capital gains can be prohibitive. This is where index funds are far superior - there is little capital gain from turnover and the fund won't crash due to bad management, so you shouldn't need to sell it.

Exchange Traded Fund (ETF) vs Indexed Mutual Fund

ETFs started in the late 1990s and have become very popular. They are baskets of the stocks, usually chosen from a stock index, that are traded on the stock market. They cover the same investment area as indexed mutual funds. (Actively managed ETFs exist, but not a lot so far).

ETFs have two important advantages over indexed mutual funds. First, you can buy or sell shares whenever the stock market is open, rather than only at the end of the day.

Second (this is my understanding), when someone trades ETF shares, they are usually buying or selling to other people, via the market. Since the fund is not selling stocks there is no tax event for other shareholders. And when someone wants to sell shares but there is no buyer, rather than selling the stocks that comprise the share and paying the seller in cash, the fund gives stocks to the seller who is responsible for the tax event. So no tax event for the fund. This is all transparent to the shareholder. This makes holding an ETF significantly more tax efficient than a mutual fund.

Advisors

I am not going to take a position on whether or not you need an advisor. But here are a couple of things to consider.

A fee based advisor takes a fixed fraction of your assets every year, typically 1%. They like to advertise that they are incentivized for you to make money - as your assets grow their advisor fee grows. This is true. But they still make money even if your assets shrink. They are taking a fraction of your assets, not a fraction of your asset growth.

So is the advisor management going to cover the cost of the 1% fee? Apparently active mutual fund management generally fails to deliver above index performance. So why expect an advisor to do better?

But without an advisor, it's all up to you - choosing a strategy, implementing the strategy, monitoring the implementation, adjusting to the current situation. And this is through distinct investment phases, each having different rules -

• before retirement
• after retirement but before taking Social Security payments
• after taking Social Security payments but before RMDs
  
• after RMDs start.