The Best Way to Invest in Index Funds

My Comments: It’s important that some of your money be exposed to the risks and rewards of the stock and bond markets. Not all your money, perhaps 25% of it.

So what’s the next step? There’s an increasing awareness of fees and commissions and how they have the potential to erode the value of your holdings over the years. If someone is adding value to your life, it’s appropriate they be compensated fairly. The challenge is to determine what is fair.

Index funds are among the most cost effective choices to build a well diversified portfolio. Many of us have the ability to be passive investors, even stepping up our game from time to time to be active investors. If you need help beyond that, look for someone willing to do it for you for about ½ of 1% per year.

Nellie S. Huang / February 2017 / Kiplinger

Investors’ passion for indexing these days reminds us of a classic Cole Porter lyric: “Birds do it, bees do it, even educated fleas do it.” Yep, everybody, it seems, is falling in love—with index funds. Since 2010, investors have withdrawn a net sum of $500 billion from actively managed U.S. stock funds and invested that amount and more in index-tracking mutual funds and exchange-traded funds. But one of the cardinal rules of investing is that whenever everyone agrees on something, chances are high that just the opposite will occur. So could indexing be the wrong way to go?

The answer: yes and no. The benefits of indexing are indisputable—the strategy is cheap, it’s transparent, and it’s no-fuss (once you’ve decided which benchmarks you want to track). And in recent years, indexing has worked particularly well with the world’s most widely mimicked benchmark, Standard & Poor’s 500-stock index. Over the past five years, the S&P 500 generated a cumulative gain of 98% (14.7% annualized). During that period, only 14% of actively managed, large-company mutual funds beat the index. (All returns are through December 31.)

But indexing has its shortcomings, too. It’s not as effective in some categories as it is for large-capitalization U.S. stocks. If you index, you cannot beat the market; actively run funds at least give you the chance to outpace a benchmark. Plus, says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors newsletter, “good timing” is required even in indexing. In particular, this may not be the best time to hitch your wagon to the S&P 500, which is what many people think about when they consider indexing. Indexing’s defenders may scoff, but there have been times—long stretches, even—when active managers dominated their benchmarks.

In the end, your best strategy may be to own a combination of index and actively managed funds. Choosing good active funds is key, of course. The other trick is knowing which markets or market segments are best suited to indexing, and in which slices active funds stand a better chance of winning. Below, we tell you where to index and where to go active.

The indexing advantage

The price is right. Index funds buy and sell securities less frequently than actively managed funds, so they incur fewer trading costs. More important, index funds charge substantially lower fees. The expense ratio for the typical actively managed large-company stock mutual fund is 1.13%. But mutual funds and ETFs that track large-cap U.S. stock indexes cost 0.49%, on average, and many charge far less.