Financial Literacy - Financial tuneup
investing
Advice from the index-fund mastermind

Switching to indexing

q_v2.gifShould people who do not currently hold index funds sell their actively managed funds and move the money to index funds, or should they hold those and start investing their new money in index funds?

a_v2.gifA lot depends on the kinds of funds they own. We've got an industry that makes life very complicated for investors because we've got dozens of different types of funds, different investment styles, different market capitalizations, specialty funds that are in telecommunications, gold, technology or whatever it may be, and a whole variety of international funds, including some that invest in just a single country. The more concentrated those investments are, say, in a single country or a single industry, I'd say the answer is generally yes, move to an index fund -- but watch out for taxes. If the funds are in your retirement plan, you can ignore taxes, but if they're in your own account, you want to take into account the tax cost involved.

Another factor to consider is how much it's costing you. The record is very clear: High-cost funds do considerably worse than low-cost funds. How could it be otherwise?

Think about diversification when you're deciding what to do, and think about cost.

Costs add up
q_v2.gifThat brings me to my next question. You've made the point time and again that costs dramatically impact investor returns. No-load funds are preferable to load funds, naturally, but how important is the expense ratio?

a_v2.gifLet's take the question a little bit differently, if I might. There are three costs that are involved in mutual funds. The one that we talk about the most and the one that is the easiest to calculate is the fund's expense ratio. That averages about 1.5 percent for an equity fund and about 1 percent for a bond fund. That's a heavy drain on your returns, unless the money manager has superior ability, which over the long term very few do. People look good in the short term and then they fade in the long term. Working with low-expense ratio funds -- as I call it, fishing in the low-cost pond -- is one way to make sure your returns are improved.

There's a second cost that we don't pay nearly as much attention to and which we don't quantify very often, and that's the impact of a sales commission -- if you buy a fund with a load. For example, if the load is 5 percent, which is the typical load today, and you hold the fund for five years, that has cost you 1 percent a year. If you hold it for 10 years, it's a half a percent a year. Think about three-quarters of 1 percent a year, the combination of those two, as cost No. 2 after the expense ratio.
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