Index Funds
I heard index funds are cheap & safe
Well, let’s start with an admission. You are correct index funds are cheaper and you won’t catch me arguing with you on that. However, it is extremely hard for me to figure out how someone comes to that conclusion they are safer. Typically, when people say the word safer, they’re referencing either how much or how often they may lose, is that how you’d look at it? If that is your definition, I’d argue that there is a severe misunderstanding of what an index fund is when someone claims it’s safe or safer. Also, important to mention is that it doesn’t (and I’d argue shouldn’t) have to be one versus the other; they both have their places and times whether that be specific asset classes, periods during an economic cycle or stage in one’s life.
What is an index fund?
In the debate over whether to use actively managed funds or index funds, or for that matter how much to invest in each one it is important to understand that an index is intended to do nothing more than mimic the returns of the market index it was built to follow and while that may not matter to most usually, I’d urge you to think of 2000-2001, 2008, 2022. These are time periods where most stock indices had very rough years and it would be wise to understand that with an index fund you are not paying a fund manager to sell investments that may no longer make sense because if a company is one of the largest 500 publicly traded in the US it is extremely likely that it is in the S&P 500 index. Therefore, when the S&P lost 22% in 2002, -37% in 2008, and -19% in 2022; those are the returns you should expect out of an S&P 500 index fund during those time periods. There are times where you may be less concerned about a certain index and be comfortable using an index fund to minimize some of the cost in your portfolio, just keep in mind index funds are not immune to market volatility, or risks associated with individual stocks. For example, if a company that is heavily weighted in an index experiences a significant decline in its stock price, the index fund will also experience a decline.
Heard actively managed funds don’t beat the index though?
Well, first off does beating an index mean you are any closer to retiring or buying that dream home? That’s a question for another post. There are times when actively managed funds have proven to be worth the increased expense ratio by outperforming the index over the long term and during significant market downturns. For example, the Baron Partners Fund (BPTIX) has outperformed the S&P 500 index by an average of 3.5% per year over the past 10 years. Another example is the T. Rowe Price Capital Appreciation Fund (PRWCX), which has outperformed the S&P 500 index by an average of 2.5% per year over the past 30 years. Both of those examples the return above the index is larger than the expense ratio of the fund and quite honestly the S&P is a level or two more aggressive than the latter example. An extreme example as far as expense ratio (although there are plenty higher than this) would be the Catalyst/Millburn Hedge Strategy Fund which has a net expense ratio of 1.99% but in a year like last year when they gained 7.72%, I would think harder about how you define value vs. cost since the MSCI ACWI index Morningstar uses for them was -18.36%. I don’t know about you, but I would not quickly dismiss a 26% outperformance solely because it costs 1.99%. Point being the discussion isn’t as simple as most would have you believe, active management doesn’t always about juicing up returns, sometimes it’s about managing risk and value received in relation to the cost paid.
The choice between index funds and actively managed funds is not a one-size-fits-all conversation. It is crucial to consider your individual circumstances, financial goals, and risk tolerance when making investment decisions. Carefully weigh your options, conduct thorough research, and seek guidance from a trusted financial advisor to make an informed decision that aligns with your investment strategy and the plan you have for funding living the rest of your life on your terms. Remember, investing is a journey, not a destination. Embrace the process, learn from your experiences, and make informed decisions rather than influenced.
Please note that this blog post is for informational purposes only and is not intended as investment advice. It is important to consult with a financial advisor before making any investment decisions. If you have any questions or would like to learn more about our services, please call us at (630) 579-3804 or email me atjp.lacour@raymondjames.com.
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