Fund Commentary with Steve Schoepke

Index Funds: Appeal to the Cost-Conscious, "Uninvolved" Investor

In the 1980s, index funds, or as they are sometimes called "passively managed" funds, gained the interest of large institutional investors, particularly pensions, seeking an economical means of allocating retirement plan assets to broad segments of the market. The fact that at the time, the performance of many actively managed mutual funds lagged their benchmark indices, and charged hefty fees to boot, made the decision to use index funds easier. Individual investors soon saw that they too could benefit from using index funds. The fund industry responded by introducing new index funds covering the range of equity and many bond fund classes.

A big attraction of index funds to the average individual investor, like me, is their relatively low cost. Because index funds do not require portfolio managers to select individual stocks and actively make trades, a whole layer of cost is eliminated - no small thing when you you're talking about upwards of 1% or more in per year savings in management fees. At the same time, because their portfolio holdings are not actively traded, index funds are tax efficient, meaning they don't experience capital gains (or losses) and related shareholder tax consequences.

However, in my mind the biggest plus of index funds, especially for investors who stick with the very broadest indices, is that they "automatically" capture the average market performance. This means that investors don't have to worry about whether they are positioned in the right market segment -- a daunting and frustrating task, especially when markets are as volatile as they've been recently.

But investors should be aware that by relying solely on index funds, they risk missing performance run-ups in select market segments or investment styles. For example, during a market favoring growth stocks, a momentum manager may out-shine the growth-at-a-reasonable price funds. For broad-based index funds, investors are not able to fine-tune to a specific investment, and as a result, may be unknowing exposed to sectors where they don't want to be.

Fortunately, for long-term investors (again like me), such temporary and often short-lived sector performance spikes smooth-out over time. When they do, history tells us they revert to the performance average, which is what index funds provide. Oh, and did I mention that their fees are lower?

Steve Schoepke is an economist with more than 25 years experience within the mutual fund arena. His expertise is in fund portfolio analysis and due diligence and he has worked in that capacity for firms such as Lipper Inc., Sun America and Alianz. Steve's M.S. degree is from the University of Wisconsin.

#