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.

If you employer matches your 401k contributions:

1. Invest in your 401k up to the amount to get the maximum match
2. Then invest in a Roth IRA if you are eligible
3. Then invest in your 401k again (no match)

If you employer does not match

1. Invest in a Roth IRA if you are eligible
2. Invest in your 401k

The situation is more complex if you are not eligible to contribute to a Roth IRA  with many contingencies that are best handled on a case by case basis.  Also, if your employer has a high cost 401k plan you may actually be better off investing some of your funds outside of your 401k in a regular taxable account once you have invested enough to receive the maximum 401k match.

The reason why Roth IRA contributions are a better bet for most people vs. a regular 401k contribution include:

1. Tax rates are likely to be higher than they are today in the future when you withdraw your 401k contributions.
2. You will have Required Minimum Distributions from a 401k plan at age 70-1/2.
3. Your heirs will required to take distributions from your 401k plan and pay taxes on them.  There are no required distributions from a Roth IRA and any distributions are tax free.

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.

They would rather have the guaranteed lower cost of an index fund vs. the unfulfilled promise of better performance through an actively managed fund.

This is the strategy that I use with my clients.  Although some actively managed funds will out perform an index fund the percentage that do is actually less than chance would predict.  It is also difficult to predict which managers will outperform and index fund year after year.  This is especially true for bond funds.  According to Morningstar the Vanguard Total Bond Market Index Fund has outperformed 83% of its peers over the last 10-years.

Index funds charge substantially less than their actively managed peers.  A low cost index fund costs about 1% per year less than its actively managed peer.  That means that the actively managed fund would have to outperform the index fund by 1% per year just to be equal.  That is very difficult to do for almost all managers.

Check the http://www.napfafoundation.org/ website for updates on when the bus will be coming to you.

For joint filers the rebate begins to get phased out when you Adjusted Gross Income (AGI) is greater than $150,000. After that you lose $50 for every $1,000 your income is over the threshold.  For example, if you AGI is $160,000 you rebate is reduced by $500.

For those filing as single the threshold for a reduced rebate begins at $75,000.  Your $600 rebate would be reduced to $0 once your AGI reaches $87,000.

For those of you getting a rebate below are 5 great things to do with it:

1. Increase your contribution to your employer’s 401k/403b to get the full match. For an employer that matches $.50 for every $1 you contribute your $600 rebate is instantly worth $900.

1. Contribute to a Roth IRA.  With a Roth IRA your earnings grow tax free. In 25 years that $600 could be worth $4800 with no tax due when you withdraw it!

1. Pay off high interest credit card debt.  If you are paying 24% interest on a credit card paying it off is like getting a 24% return on your investment.  Paying $600 would save you $144/year in interest payments

1. Start an emergency fund.  This is the money you use when the car breaks down etc. instead of running up a credit card debt.  Open a high yield internet savings account at www.ingdirect.com, www.emigrantdirect.com or check www.bankrate.com for the latest savings rates.
2. Open a 529 account for college savings.  The Bright Start Illinois Plan was ranked as one of the best in the nation by the Wall Street Journal.  Plus Illinois residents get a state tax deduction for any money they contribute. See www.brightstartsavings.com

]]> http://longfinancialplanning.com/blog/2008/05/01/why-you-may-not-get-a-rebate-check/feed/ 0 http://longfinancialplanning.com/blog/2008/02/08/more-attention-focused-on-401k-fees/ http://longfinancialplanning.com/blog/2008/02/08/more-attention-focused-on-401k-fees/#comments Fri, 08 Feb 2008 17:22:50 +0000 Chris Long http://longfinancialplanning.com/blog/2008/02/08/more-attention-focused-on-401k-fees/ The Marketplace radio show on National Public Radio recently ran a two part segment on 401k fees. They focused on how small employers and their employees don’t understand these fees and how much they can reduce retirement savings.

Of course, the banks,brokers, and insurance companies think the present system is pretty good. After all, if people don’t know what they are paying they are willing to pay a lot!

Listen to Part 1 of the show

Listen to Part 2 of the show

If you are responsible for your small organization’s 401k plan and want to find out how to get a low cost plan with full fee disclosure that’s easy to understand, check out my website for employer plans at http://www.longfinancialplanning.com/for-business-and-non-profits