5 Reasons Investors Should Favor Index Funds, ETFs

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Investors seem to have made up their collective minds in deciding that passive investing -- index funds and exchange-traded fund that track the market benchmarks like the S&P 500 (^GSPC) -- is preferable to actively managed funds, where stock pickers try to outperform the market averages.

And recent results seem to suggest that's the wisest course to follow. According to S&P Dow Jones Indices, more than 86 percent of large-cap fund managers underperformed the return of the S&P 500 last year. And this is not a blip: over a five-year period, 88 percent active fund managers underperformed, and over the past 10 years (which includes the financial crisis and the subsequent market tumble), 82 percent underperformed.

What Warren Buffett Thinks

Here are five good reasons why you should favor a hands-off approach to investing:
  • Management fees are low. The biggest advantage of index funds is that they cost very little to operate, so management fees are just a tiny fraction of what actively managed funds charge their investors. Vanguard Group charges as little as 18 cents for every $100 invested, according to company spokeswoman Adrianna Stefanoni Sherlock. That compares with an average of $1.24 per $100 invested in the average actively managed mutual fund. Vanguard is by far the industry leader in selling index funds. It has more than $3 trillion under its management, and last year investors poured a record $216 billion into its mutual funds.
  • Warren Buffett has climbed on board the bandwagon. The world's most famous market guru told his Berkshire Hathaway (BRK-A) shareholders last year that he wants trustees of his fortune to put 90 percent of his money into a plain vanilla "very low-cost S&P 500 index fund." He said the results "will be superior to those attained by most investors ... who employ high-fee managers." The mantra of index fund investors is to keep costs as low as possible, and over time -- maybe 20 or 30 years of investing -- the savings from using low-cost funds will add up to tens of thousands of dollars. And each year, you can reinvest that money, adding to your long-term returns.
  • The low cost is directly linked to performance. That's what investing is all about. Let's say stocks gain 6 percent a year. If you're paying an active fund manager 1¼ percent to manage your investment, he's going to have to outperform the index fund by nearly that much just for you to match the performance of the passive investment. Very few portfolio managers have been able to do that for long. "In predicting good performance, cost tends to be the most predictive factor," according to Christine Benz, Morningstar's (MORN) director of personal finance.
  • Index funds and ETFs are much more tax efficient. Taxes are due when you sell a stock or bond at a profit (except when they are held in tax-deferred retirement accounts). But as many investors discovered during the current tax season, you don't have to sell a mutual fund to incur significant capital gains exposure. Many actively managed funds paid out big distributions last year, as they sold stocks in their portfolios that had run up sharply over the course of the six-year bull market, generating a tax hit for investors, whether or not they sold any shares. And many of these actively managed funds were indeed very active in buying and selling stocks within their fund portfolios. On the other hand, an index fund rarely changes the make-up of its portfolio. Most of the capital gains it generates come from companies are dropped from the index or acquired.
  • Index funds and index-based ETFs are much simpler. You don't have to worry so much about diversification, because a broad-based index already does that for you. You don't have to monitor the fund on a regular basis, because you know exactly what's in it. And you don't have to worry so much about rebalancing your investment, because the index funds are in effect doing that on an ongoing basis.
As passive investing has become more and more popular, with investors pouring billions of dollars into them each year, "price wars have broken out that have been good for consumers," according to Benz. "Vanguard's dominance has pushed other providers to lower their costs." Other major fund companies offering low-priced index funds include Fidelity, T. Rowe Price (TROW), Charles Schwab (SCHW) and BlackRock (BLK).

Some actively managed funds have consistently outperformed their benchmark indexes. Proponents also note that actively managed funds often fare better than index funds during down markets. The index funds are always fully invested -- and thus fully exposed -- while active funds can usually move into cash or other investments when the market is falling.

And for some investors, index funds are simply too boring. You're accepting a hands-off approach to investing, settling for singles instead of home runs, and accepting that you will never "beat the market."
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