Low-Cost Index Funds or Managed Mutual Funds?

Should you be using low-cost index funds or managed mutual funds in your portfolio? There’s a new study by the Journal of Financial Planning and the FPA Research and Practice Institute™ showing that more and more advisors continue to use exchange-traded funds.

An exchange-traded fund, or ETF, is a collection of securities traded on a major stock exchange. Most ETFs track an index, a popular example of which is the S&P 500. With low-cost index funds, investors have the option to be very granular regarding the asset class they choose to invest in. You can track U.S. Company Small-Cap Value Stocks, you can track commodities, gold… you can track just about any index imaginable.

According to the survey, 87% of advisors say they recommend or use exchange-traded funds with their clients. Now, that doesn’t mean mutual funds are phased out. 73% of advisors still recommend or use mutual funds. To me, these responses make for a good topic for conversation.

It seems like I hear more and more advisors trying to focus on using one investment option or another; they believe in managed mutual funds OR they believe in unmanaged index funds. My stance is, why not both? There are advantages to both investment vehicles. Why would we want to exclude a particular approach from the investment of your life savings?

With low-cost index funds, there are typically lower costs associated and you’re more likely to you know what you’re going to get because they’re going to track the index very closely. Actively managed funds, on the hand, have a higher cost but come with some managed expertise. The argument against active management is that just because an investment manager has done well in the past, that doesn’t guarantee future delivery. And while that’s true, I equate it to an analogy about rowing versus sailing.

Think about being out on the lake in a sailboat. The question is, do you just sail or do you have to row the boat? How are you going to get about? Let’s say the wind is at your back and because the tail winds are good, you can just lift up those sails and sail. You let the winds take you where they’re going. That’s the equivalent of index funds. When markets are good, there’s no question that there is a lot of benefit to index investing because the winds are able to take you exactly where you want to go.

But what if you’re going against the wind and there are headwinds? You don’t necessarily want to just go where the wind is taking you. When we see challenging up-and-down choppy markets, market corrections, or even bear markets, that’s when you need that rowing. Many investment managers that run mutual funds have a track record for being very effective in turbulent economic times. True, just because they’ve been effective in the past doesn’t mean they’ll be effective in the future. And yes, I think many managed mutual funds perform mediocre or poor, BUT the best ones can be very effective.

We don’t know what the next two three years are going to be in terms of the markets. We don’t know if we’re going to want to just sail or we’re going to have to row in the headwinds. Therefore, my thing is, why not use both? There are advantages to both.

There are some great managed funds that control management fees and have given tremendous net returns to their investors. They’re also there’s also a lot to be said for low-cost index investing. It does need to be managed in a portfolio. It has to always be weighed index funds versus managed funds. But why would you ever want to just focus on one class of investment with all the different things that are out there?

I’m not saying that advisors who preach one or the other haven’t put thought into their recommendation. But, to me, it’s short sighted and shallow to think that any one investment approach is the only thing that you need.

A fee-based platform allows you to consider all of your possibilities without worrying about commissions getting in the way of conflicted investment advice. If your advisor is fee-based, there’s a fiduciary responsibility to work solely in your best interest. With that, there’s no commissions on buys and sales of securities. Why, then, would you not want to consider all of your options and look outside of the box? Great management looks at everything, but then applies it to what you want to accomplish with your money.