THE SHOPPING MALL OF INVESTMENTS
index funds, the fund managers merely track the index. They don’t
have to pick individual securities.
PROS AND CONS OF INDEX FUNDS.
One of the advantages of own-
ing an index fund is a tax advantage. Since the funds track the mar- ket indices and aren’t actively managed, there is little security turnover, resulting in lower capital gains distributions. Thus, really, the shareholder would only have to worry about any interest or divi- dends that would be declared and passed through. With low turnover of securities, this also leads to lower costs for the fund. There are low transaction costs, as well as minimal research and investment-man- agement fees.
Another possible advantage is that the funds are directly tied to the stock market. Many times, mutual funds that are actively man- aged will try to beat the market. And while some have done so, many have not. By investing in an index fund, you minimize your chance of being invested in a fund that performs worse than the market. How- ever, that also means that you may miss out on some tremendous per- formances by other actively managed funds when they outperform the market. Many people believe that actively managed funds do out- perform index funds during down markets. According to a recent study by the Schwab Center for Investment Research, over a period of 20 down markets between 1987 and 2000, the average actively managed large-cap mutual fund outperformed the average S&P 500 index fund only half of the time.1 Therefore, the average index fund outperformed the average actively managed fund half of the time, as well. This, of course, is not a case of one type of mutual fund doing so much better that you should forsake the other type of fund. Rather, sometimes a nice mix of actively managed funds and an index fund may be a good fit for your financial objectives.
As with any type of investment, there are limitations to index funds. One is that because the funds’ portfolios mirror the market indices, some of common stocks’ better performers’ returns may be undermined by other, lesser-performing assets. Since the funds are passively managed, the fund managers wouldn’t be selling off some
1“Do Actively Managed Funds Outperform in Down Markets?” by Mark W. Riepe, CFA. Journal of Financial Planning, July 2001.