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The right way to invest in index funds

Index funds have been gaining popularity over the past twenty years because of low taxes and good performance relative to higher fee funds. However, for tax-deferred retirement plans or IRAs, the only advantage is low cost. If you take away the low cost advantage, index funds no longer have any special benefits compared with traditional mutual funds.

As with every investment, a little understanding goes a long way. Mutual fees are called expense ratios. Expense ratios represent the cost to operate the fund. Index funds claim a cost advantage over actively managed mutual funds or higher fee mutual funds. This lower cost translates to higher returns; allowing index funds to beat the majority of actively managed or higher fee mutual funds over the long term.

The most common investment mistake I see is investors paying someone to manage a portfolio of index funds or traditional mutual funds using a buy-and-hold or asset allocation strategy. For investors, this is a swing and a miss on several levels. The reality is that companies like Vanguard can provide diversified portfolios that are better than financial advisors can provide, in most cases, and do so at a lower cost. This is not a criticism of financial advisors, just recognition of a fact. If you doubt this, take one of the popular Vanguard funds and see how your returns compare after fees are taken into account.

Paying an advisor or planner to manage an asset allocation or balanced portfolio of index funds puts your portfolio in the same position as a high fee mutual fund manager. Adding a 1% advisory fee to your index fund portfolio negates the entire advantage of using an index fund in a retirement plan. The truth is you will never realize the index fund benefits you sought if you pay someone to manage an index fund portfolio. No value can be added by paying advisory or management fees for holding an index fund for years or for decades. Unless a trading strategy is being used, the potential to add value is zero.

Second, if we are holding a mutual fund for a very long time – decades or more – does it make sense to pay 1%  a year  just to hold something for ten or twenty years? Should we pay 20% in fees over twenty years if we are going to keep the same basic portfolio?

I do think financial advisors and planners can have tremendous value for investors, but just like bond funds, you have to know what you are doing to avoid negating the very benefits you sought out in the first place. If you want to get the proposed benefits of index funds, then you can’t pay fees, or must pay ultra-low fees to get what you really want.

You can use the fund company website or sites like www.morningstar.com to find the expense ratios for your mutual funds and exchange traded funds.  Add the mutual fund expense ratio to what you are paying in advisory and management fees to see what you real fees might be. You may be surprised how much you are paying in fees with little chance of any real value being added.  Anything over .5% in total fees for index funds and advisory fees combined should be questioned. If you want to be a better investor by tomorrow, then take a few minutes to see what you are really paying for when it comes to fees.

 

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