Index Funds Pros and Cons

[brewer12345]

FD, I can see only a few reasons to buy a managed fund, especially snce there is such a proliferation of index funds these days:

- When a managed fund offers exposure to an asset class that you cannot buy an index fund for. I'm still waiting for a non-USD bond index fund, so in the meantime I choose to own GIM. Still waiting for the Venezuelan Beev3r cheese futures index fund...
- When the asset class is very illiquid/idiosyncratic. High yield munis is something I would want a very sharp manager running, not an index.
- When the active manager is willing to work cheap and appears to have a good track record. I am thinking of Wellington, for example.

That's about it. Other than that, I suppose you can make a case that you have found a truly superior manager running a mutual fund, but I reserve the right to be skeptical/laugh at you.

 

[Rich_by_the_Bay]

Once paid a guy 1.5% management fee at Bernstein-Alliance for virtually all my investments. He has actually outpaced the index by a small bit for a couple of years, net of fees. As I got smarter I realized that with my fixed income allocation, he was putting it in the Bernstein bond mutual funds; so I was not only paying the fund's expenses, but also 1.5% on an investment returning maybe 5%.

I talked this over with him, and he -- to his credit -- agreed that I'd be better off handling that piece on my own (which I'd already told him I was going to do). He added something about how it's something they do for investors who prefer to have one-stop shopping, etc.

So I pulled my fixed income out. At 59.5 years of age, I'll probably roll over the equities he still manages for me to my Vanguard IRA but since he's doing OK with it for now (even after fees), no rush. These are invested directly in (many) individual stocks, so part of that 1.5% would be offset by mutual fund fees if I did it myself.

It's been a weaning process for me. The most reassuring evidence that I can do this all myself (without active management from either an advisor or fund managers) is that everytime I look at the stock market, the Bernstein account has done almost the same as the relevant indices. Haven't lived through a bear market with him yet, though.

 

[FinanceDude]

Expenses and costs matter.  Good luck buying 500 stocks every month or quarter or year as you accumulate assets during your working years.  I think I'll stick to paying 10-20 basis points a year to fidelity and vanguard in exchange for this service.  Buying individual stocks in the SP500 is relatively simple when you compare it to buying the 5000 stocks in the Wilshire 5000, or all the stocks in the MSCI EAFE or the MSCI Emerging Markets Index (all of which can be had for 30-45 basis points). 

You missed my point entirely. What I was saying was YOU would not PAY Vanguard 65-75 basis points a year to buy the 500 stocks of the S&P.............it is NOT HARD to do for Vanguard or anyone else.................and takes little thought and trading.............

I know with a high degree of certainty that I could run an above average "managed fund".  All I'd have to do is put out some glossy brochures about "superior outperformance", market diversification, outpacing inflation, careful security selection, blah blah blah.  Then go buy a couple of index funds from VG institutional and be home at 5:00 for dinner.      

You say "I submit it's a lot harder to beat the index than most think, and as a matter of fact few do".  Then what is the point of paying out the wazoo for active management when so few can outperform the index? 

Bottom line is that since you are a financial planner making big bucks off of commissions, what are you going to recommend?  American Funds with a 5.75% front end load and a residual 0.25% payment every year from the 12b-1 fee or a Vanguard index fund with a $50 fee and much lower long term expenses?  If I was in your shoes, I know which one I would recommend.  At least be honest about your motives.

First of all, I work on fees, not commissions...........second, you can find companies that outperform the S&P quite handily............Dodge and Cox come to mind, and others. I appreciate the Vanguard passion, but don't be so close minded, I don't recall anyone paying 5.75% to buy Dodge and Cox or T Rowe Price in recent memory.........I have done better in my managed funds the past 7 years than any Index fund I own, Vanguard included............

To each their own..................

 

[astromeria]

I also have some $ with a broker (it was originally 20% of our port) in individual corporate bonds (and in 2003 when bond coupons were bottomed out, I got a 10-year CD and IGR--global REIT fund--which she sold me out of just before the big growth spurt this year ). Since we're not living off the proceeds yet, and I haven't bought anything new with her for over a year, I take the income and capital from called/sold bonds to invest myself. Eventually this account will practically close itself (I'm such a wimp-).

 

[FinanceDude]

Once paid a guy 1.5% management fee at Bernstein-Alliance for virtually all my investments. He has actually outpaced the index by a small bit for a couple of years, net of fees. As I got smarter I realized that with my fixed income allocation, he was putting it in the Bernstein bond mutual funds; so I was not only paying the fund's expenses, but also 1.5% on an investment returning maybe 5%.

I talked this over with him, and he -- to his credit -- agreed that I'd be better off handling that piece on my own (which I'd already told him I was going to do). He added something about how it's something they do for investors who prefer to have one-stop shopping, etc.

So I pulled my fixed income out. At 59.5 years of age, I'll probably roll over the equities he still manages for me to my Vanguard IRA but since he's doing OK with it for now (even after fees), no rush. These are invested directly in (many) individual stocks, so part of that 1.5% would be offset by mutual fund fees if I did it myself.

It's been a weaning process for me. The most reassuring evidence that I can do this all myself (without active management from either an advisor or fund managers) is that everytime I look at the stock market, the Bernstein account has done almost the same as the relevant indices. Haven't lived through a bear market with him yet, though.

Bottom line is, you paid someone to manage your money for you until you had the time/felt comfortable doing it, and that's the key.

I have some clients I have told to manage their own money, and have helped them set up the accounts to do it. I'm not going to fight anybody who thinks 1% a year on their assets is too much to pay........life is too short............

 

[justin]

You missed my point entirely. What I was saying was YOU would not PAY Vanguard 65-75 basis points a year to buy the 500 stocks of the S&P.............it is NOT HARD to do for Vanguard or anyone else.................and takes little thought and trading.............

I thought your main point was "how hard is it to buy the 500 stocks of the S&P 500 in the right weightings to track the index?". I'd say pretty hard for an individual investor. It would take me probably two days at least to determine the correct quantities of the 500 stocks to buy and to execute the trades and then I'd have to pay thousands in commissions. Vanguard (and other indexers) provide a very valuable service for 10-20 basis points. My point is that it is impractical for most individual retail investors to buy all the components of indexes.

 

[justin]

First of all, I work on fees, not commissions...........second, you can find companies that outperform the S&P quite handily............Dodge and Cox come to mind, and others. I appreciate the Vanguard passion, but don't be so close minded, I don't recall anyone paying 5.75% to buy Dodge and Cox or T Rowe Price in recent memory.........I have done better in my managed funds the past 7 years than any Index fund I own, Vanguard included............

Good luck continuing your outperformance for you and your clients. Watch out for Dodge and Cox - their performance has dropped like a rock in the last 6-9 months. The days of their funds being in the top 5% in their fund categories are over. Another story of how the party was great as long as it lasted. Problem is, everyone was late to the party.

I do think Dodge and Cox and other actively managed mutual funds (TRP, American Funds Class A ignoring the loads, etc) who have relatively low expense ratios will continue to do ok - above the 50th percentile as long as their ER stays low.

Let me know if you have any "hot picks" for funds that will be in the top 5% over the next 5-10 years. I think you'll have a lot of receptive ears here.

 

[terminator]

Even if you are a true believer in Bernstein, there are times it can make sense to do it on your own.  If you are beyond the early and small accumulation phase and willing to live with the volatility that Bernstein shows in his charts from owning a smaller number of diversified stocks, there's no reason you can't do it yourself.

Cost example: buy 50 positions averaging $20k each.  That's $1MM (a realistic sized portfolio).  50 buy orders at a discount broker would cost about $500.  That's .05% expense which is lower than the lowest annual index fund fee.  Unless you churn like crazy (in which case you shouldn't be doing it yourself), your expenses will be lower.  It is easy to administrate these days if you hold them all in a brokerage account.  You get to make the tax decisions for yourself.

Our OP could buy 25 $10k positions for an expense of .10% and just continue adding positions with each additional $10k.

The downside is you might have greater volatility and (for diehards) you might be worried about not getting a return that is identical to market return.  If you can live with those potential downsides and like the upside of completely controlling your tax destiny, having marginally lower expenses and having more control over what you hold, then doing it yourself might make sense.

Of course it's all colored by our past experiences as well.  Managing my money myself I've beaten the S&P returns for the last 15 years on the stock portion of my portfolio so even if I revert to the average or slightly below, I'm not worried since I'll still be ahead.  Someone who owned tech stocks and watched 50% of their life savings disappear in a year or two would probably be more comfortable putting it on auto-pilot in index funds.

 

[Nords]

Over the long term, Index funds tend to outperform their counterparts because of the cost advantage. However, the actively managed funds perform slightly better during a bear market since they have the freedom not to be fully invested in the market. During a bull market, the actively managed funds tend to do worse since they may be late in getting back. The following link has an explanation about this.
http://news.morningstar.com/article/article.asp?id=115580&_QSBPA=Y

Whenever I read reassuring "studies" like this one, I wonder if the money saved by those nimble actively-managed funds during bear markets exceeds the fees collected during all markets.

As for American or Dodge & Cox, one word: bloat. You can't bloat an index fund.

 

[justin]

Even if you are a true believer in Bernstein, there are times it can make sense to do it on your own. If you are beyond the early and small accumulation phase and willing to live with the volatility that Bernstein shows in his charts from owning a smaller number of diversified stocks, there's no reason you can't do it yourself.

Cost example: buy 50 positions averaging $20k each. That's $1MM (a realistic sized portfolio). 50 buy orders at a discount broker would cost about $500. That's .05% expense which is lower than the lowest annual index fund fee. Unless you churn like crazy (in which case you shouldn't be doing it yourself), your expenses will be lower. It is easy to administrate these days if you hold them all in a brokerage account. You get to make the tax decisions for yourself.

Our OP could buy 25 $10k positions for an expense of .10% and just continue adding positions with each additional $10k.

If you have a million laying around, you can probably find an institutional fund with a 0.05% expense ratio. I know Fidelity has a number of Spartan Advantage class funds with ERs of 0.07% and only $100k minimums. The advantage of the mutual fund ownership structure is that you can sell and buy shares with no additional transaction fees (unlike a stock portfolio).

 

[haha]

I have some clients I have told to manage their own money, and have helped them set up the accounts to do it.  I'm not going to fight anybody who thinks 1% a year on their assets is too much to pay........life is too short............

Do I understand that they pay you 1% for your services? If so they are not giving up 1% per year; they are giving up 1% plus whatever the fund level or stock level expenses are. So pre-tax, they are giving up at least 1.5%.

Even if you believe that 4% is a conservative SWR (which I don't), your clients are giving up 1.5% of that 4%, or almost 40% of their SWR! It's not for nothing that expenses and fees are always expressed as a % of assets, not as a % of average returns. And 25% of their SWR goes to your fees, which while important to you, really accomplish nothing that the client couldn't accomplish with a bit of reading. He could just come to this board and take Wellington. It may not be perfect, but it isn't bad and it is cheap.

I would say that the clients' lives may be too long for them to really be able to afford that kind of thing.

Not that I  think you shouldn’t get your fees however you can, but caveat emptor does apply here as in most places.

Ha

 

[FinanceDude]

Whenever I read reassuring "studies" like this one, I wonder if the money saved by those nimble actively-managed funds during bear markets exceeds the fees collected during all markets.

As for American or Dodge & Cox, one word:  bloat.  You can't bloat an index fund.

Interesting how much stock people put in Morningstar...............I'll bet 80% of all investors have no idea how Morningstar assigns their star ratings...........or why those star ratings are very subjective and biased............

 

[saluki9]

Interesting how much stock people put in Morningstar...............I'll bet 80% of all investors have no idea how Morningstar assigns their star ratings...........or why those star ratings are very subjective and biased............

"subjective and biased"? I think worthless or sucks is more fitting

 

[FinanceDude]

Do I understand that they pay you 1% for your services? If so they are not giving up 1% per year; they are giving up 1% plus whatever the fund level or stock level expenses are. So pre-tax, they are giving up at least 1.5%.

Even if you believe that 4% is a conservative SWR (which I don't), your clients are giving up 1.5% of that 4%, or almost 40% of their SWR! It's not for nothing that expenses and fees are always expressed as a % of assets, not as a % of average returns. And 25% of their SWR goes to your fees, which while important to you, really accomplish nothing that the client couldn't accomplish with a bit of reading. He could just come to this board and take Wellington. It may not be perfect, but it isn't bad and it is cheap.

I would say that the clients' lives may be too long for them to really be able to afford that kind of thing.

Not that I  think you shouldn’t get your fees however you can, but caveat emptor does apply here as in most places.

Ha

Pretty common fee applied to investment accounts...........but that's my business models, and I price them accordingly:

$100,000 - $250,000 - 1%
$250,001 - $500,000 - .90%
$500,001 - $1,000,000 - .75%
$1,000,000 +   based on bond/equity mixture............have a few as low as .40%

If I have an account at $200,000, and half of it is in fixed income, I'll do $100,000 @1% and $100,000 @ .50% which equals $1500 a year in fees............

I have said ALL ALONG, that my clients are those that CHOOSE not to invest on their own and/or learn enough about it.  it's not like they're a bunch of dolts..........many of them have a net worth in the millions.............

One more thing:  Management fees can be deducted on your taxes, commissions can not............

 

[FinanceDude]

"subjective and biased"?  I think worthless or sucks is more fitting

Well, that about sums it up............

 

[Martha]

One more thing:  Management fees can be deducted on your taxes, commissions can not............

Commissions are deducted from the sales price when determining your gain on the sale of the asset.

 

[haha]

Pretty common fee applied to investment accounts...........but that's my business models, and I price them accordingly:

I assume that Fin. Advisors don't spend a lot of time with people who have no money, so for the most part their clients will not be dolts.

Still, I can easily imagine a busy person who might never bother to consider that the advisor is getting almost half the spendable income from an investment, while bearing none of the risk. And of course, in tough markets, he is the only one who is clearing anything.

I imagine that if you were so self destructive as to point that out to your clients, quite a few would reconsider their investment plan.  

I appreciate your honesty on this board because for the most part FPs have a pretty short half life around here.

Ha

 

[justin]

Financedude,

What happens to the 12b-1 fees and sales loads/commissions paid (if any) by your clients? That $50 fee to buy vanguard funds is an additional expense to your clients on top of the 1%/yr, right? What about commissions on stock purchases or sales? Do those come out of your 1%?

 

[donheff]

People who read this board are generally taking enough interest in personal finance to figure out how to manage their own portfolio. Also, many of us are in or near ER and the reality of maintaining a SWR over 30-40 years takes on real meaning. But in the accumulation years many of us (unwisely) considered ourselves too busy to pay attention to this stuff. An FA can come in handy for such people. It enabled DW and me to put together a nice nest egg that we now manage ourselves. Could we have done better? Maybe, but we could have done a lot worse. For those who use an FA a fee advisor like the dude here makes more sense (to me) than an FA who is biased by load commissions. Of course if the fee advisor traps you in load funds on top of the 1% something is wrong

 

[FinanceDude]

Commissions are deducted from the sales price when determining your gain on the sale of the asset.

True, but I was referring to the fact that people can deduct their management fees on an annual basis on their taxes, what you are saying is true, but happens upon sale, which could be several years out............

 

[FinanceDude]

Of course if the fee advisor traps you in load funds on top of the 1% something is wrong 

That doesn't happen a lot anymore, unless you got a famous Northwestern Mutual "wrap account" with Mason Street funds that has been shut down...........

However, "wrap accounts" are still all the rage, which is sad. Basically, it involves the client paying a management fee on TOP of the mutual fund expense, and even though a lot of the programs use institutional and A-share expenses, the program easily costs the consumer 2.00-2.50% a year.............that's a crime..............

 

[FinanceDude]

I appreciate your honesty on this board because for the most part FPs have a pretty short half life around here.

Ha

Well, I am different, I got dropped on my head when I was young and have never recovered...........

 

[saluki9]

Not that I think you shouldn’t get your fees however you can, but caveat emptor does apply here as in most places.

Ha

HAHA I work for an advisory firm. Our fee schedule is around 75BPS max and generally head down from there. Our avg account size is in the 7 figures which is why our fees are lower than most firms.

We implement our allocations mostly with ETFs and DFA funds, so say that the max avg would be 1% of total assets. I think you're mistaken in believing that ALL people are getting is investments. Most firms offer planning, advice, meeting with your other advisors,bill payment, liabilities management, insurance analysis etc. I happen to think that our firm is quite good with the services we offer. Many of our clients have are very financially astute, and have zero interest or time to do any of these activities themselves.

I know it's popular here to demonize an entire industry, but the truth is that there are some really good advisors and advisory firms out there.

 

[haha]

HAHA  I work for an advisory firm.  Our fee schedule is around 75BPS max and generally head down from there.  Our avg account size is in the 7 figures which is why our fees are lower than most firms. 

We implement our allocations mostly with ETFs and DFA funds, so say that the max avg would be 1% of total assets.  I think you're mistaken in believing that ALL people are getting is investments.  Most firms offer planning, advice, meeting with your other advisors,bill payment, liabilities management, insurance analysis etc.  I happen to think that our firm is quite good with the services we offer. Many of our clients have are very financially astute, and have zero interest or time to do any of these activities themselves. 

I know it's popular here to demonize an entire industry, but the truth is that there are some really good advisors and advisory firms out there.

Good point, thanks for taking the time to make it.

Ha

 

[Spanky]

Many of our clients have are very financially astute, and have zero interest or time to do any of these activities themselves.

.. so that they can do something else of more importance, e.g., golfing, fishing, biking, hiking.