Financial Planning Stuff You Need to Know

According to the Wall Street Journal index funds are likely to become even better in the future.  The new twist:  indices that phase out and phase in new stocks vs. adding and dropping them abruptly.  This eliminates that tactic of active managers taking advantage of the time before the index changes and the index fund buys or sells the stock.There are also some other great reasons to own index funds:

1. Lower fees. The typical actively managed stock fund has total annual expenses of 1.35% or $1.35 per $100 invested.  Index fund fees tend to me much lower.  For example, the Vanguard Total Stock Market Index charges 0.07%  or $0.07 per $100 invested.
2. Tax efficiency. An actively manage fund turns over its portfolio about three times per year.  This means that it generates capital gains on any profits from those sales and all of those gains are taxable, whether or not you sell you shares.  An index fund buys and sells shares much less frequently generating much lower annual capital gains.  Meaning that most of the tax is owned when you sell your shares, and those gains are taxed at lower capital gains tax rates.
3. Transparency. Actively managed funds only report their holdings a couple of times per year so it’s difficult to know exactly if their actual holdings match your expectations.  For example a large cap fund could hold significant small cap stocks, or a large amount of cash without disclosing it.  This could make maintaining an asset allocation more difficult.  With an index fund you have much greater transparency into their holdings since they are required to track a publicly disclosed index.

I read an interesting article in today’s Wall Street Journal about when index funds do the best vs. actively managed funds.  Index funds do the best in the asset classes that are seeing the strongest returns.  The study was based on a 10-year period from 1997-2007.  The reason for this is active managers tend to deviate from their primary asset class (e.g. Large-Cap manager buying Mid and Small Cap stocks) when the primary asset class has performed poorly and then miss the quick run up when the primary asset class recovers.

Does this mean that you should use active managers for poorly performing asset classes?   No.  The problem with this conclusion is not that actively managers are picking better stocks in their primary asset class but they are moving outside their designated asset class to try and improve performance.  When they do this they change your overall asset allocation and risk/return profile without telling you.  If you wanted to you could do the same thing with index funds but at least you would be aware of the changes you were making.

The article also did not address if they active managers’ performance was after all fees and expenses.  Actively managed funds have management fees that average 6x higher a low cost index funds.   In addition if you buy an actively managed fund through a broker you load fees in addition.  There is also the issue of taxes.    An actively managed fund turns its stock portofilio over about 3x/year which could generate signficiant short-term capital gains on which the mutual funds shareholders are taxed on lowering their overall retrun.  An index fund may only turn over 20% or less of its portfolio generating much lower taxable gains.

My advice:  Stick with low-cost index funds, for superior long-term performance.