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Bankrate's 2008 Retirement Guide
Finding the funds
Sometimes, finding that extra bit of income can turn a retirement nightmare towards a happy ending.
Finding the funds
Investing in your retirement
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In the end, all that activity often doesn't guarantee top returns.

It's not that fund managers aren't smart enough to beat the indices. But in general, most actively managed funds come with higher annual expenses that eat into performance and profits, making it difficult to beat index funds. Over the past 10 years, the cheapest S&P 500 index funds beat more than 60 percent of their large-cap blend peers, according to Morningstar.

As an example, the expense ratio for large-blend index funds averages 0.59 percent, but the annual expense ratio for an actively managed large-blend fund typically runs 1.22 percent, according to Morningstar.

That may not sound significant, but don't be fooled. A seemingly small difference in expenses can be worth a small fortune over time.

Imagine two investors with $10,000 each and deep convictions about how to invest their money. One puts his money in an index fund that returns 10 percent minus 0.20 percent in expenses. The other invests in an actively managed fund that also returns 10 percent annually but has an expense ratio of 1.22 percent. Both leave money in their respective funds for 35 years.

  • The index fund is worth $263,683 after 35 years.
  • The actively managed fund is worth $190,203 after 35 years.
  • The difference is $73,480.

Taxes are another consideration. Remember, Uncle Sam wants his piece of the action when you sell winning investments. Because actively managed funds reshuffle their stock holdings far more frequently than index funds, they trigger more taxes than index funds, which have a buy-and-hold approach.

The bottom line: With their low costs and generally higher returns, index funds usually are the best bet for most investors.

Exchange-traded funds
Mutual funds have their limitations. For starters, the actively managed variety passes on to investors the overhead costs (research and management expenses), which eat away at returns.

Funds also distribute capital gains at the end of each year, a taxable event for shareholders -- even in years with negative returns. This is true of both actively managed and index funds, though the latter are more tax-efficient.

And, because they get priced once daily at the close of the trading day, funds aren't flexible enough for investors who wish to take advantage of short-term dips and spikes in the market through intraday trading.

ETFs boom
Enter the more sophisticated exchange-traded fund, or ETF, which arrived on the scene in 1993 and has fast become the investment tool of choice for Wall Street and Main Street investors alike.

-- Posted: Nov. 10, 2008
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