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Why Do We Favor Index Funds? Thumbnail

Why Do We Favor Index Funds?

Throughout our investment careers, we have researched and implemented a variety of active and index strategies (more on these terms later) across a variety of asset classes and client types. We have overwhelmingly found that our best clients were the ones that focused on their specific goals as opposed to which (insert name of asset class here) fund to select.  No one can predict the market, and if you can’t predict the market, why would you try to pick stocks or funds that you “think” will do better?

You can’t control investment performance, but you can control fees and your investment allocation. To us, it’s important to focus on what we can control.

Defining The Terms

Active Management: involve a team of financial professionals actively buying and selling assets within the fund in an attempt to outperform a particular benchmark

Passive or Index Management: aim to replicate the investment performance of a specific market index, such as the S&P 500

The Case for Index Funds

Cost Efficiency: One of the primary advantages of index funds lies in their cost-effectiveness. Actively managed funds often come with higher fees due to the active management involved, including research, trading, and administrative expenses. These fees can significantly eat into investors' returns over time. Index funds track a particular benchmark, resulting in lower fees, thus maximizing the returns for investors. Be careful though, because not all index funds are cost effective, so it is important to understand the fee structure in place.

Consistent Performance: While some actively managed funds may occasionally outperform (or underperform!) the market, numerous studies have shown that over the long term, the majority fail to consistently beat their respective benchmarks. Index funds, by tracking established market indices, offer investors a more predictable and stable path to returns, avoiding the volatility and uncertainty associated with attempting to time the market or beat it consistently.

Diversification: Index funds inherently provide broad diversification across a market or sector. By investing in an index fund, investors gain exposure to a wide range of assets, spreading risk effectively. This diversification minimizes the impact of poor performance from any individual stock or sector, enhancing the resilience of the investment portfolio against market fluctuations.

Transparency: Another key benefit of index funds is transparency. Since they aim to replicate the performance of a specific index, investors know exactly what they're investing in and can easily track the fund's performance relative to its benchmark. 

Tax Inefficiency:  Actively managed funds tend to have higher turnover rates compared to index funds. The frequent buying and selling of securities within the fund can lead to capital gains distributions, which can be taxable for investors. This tax inefficiency can erode returns, especially for investors in higher tax brackets. On the other hand, index funds typically have lower turnover rates as they aim to replicate a specific index. This results in fewer capital gains distributions and can lead to greater tax efficiency for investors.

The Wrap

Index funds offer several advantages over actively managed funds and typically make sense for most investors.  While actively managed funds may have been popular in the past, the evidence suggests that they often fail to add value to investors' portfolios. High costs, inconsistent performance, lack of transparency, and tax inefficiency are some of the key factors that contribute to this underperformance. Investors seeking to optimize their investment outcomes may be better served by considering low-cost, passively managed funds such as index funds or ETFs.

It's important for investors to understand that this analysis does not suggest that all actively managed funds are doomed to underperform. Some skilled managers may be able to outperform the market consistently, but the challenge lies in identifying these managers in advance. Therefore, for most investors, the evidence supports the notion that actively managed funds don't add value and that a passive investment approach is often a more prudent choice.

Authored by Stephen Blahovec and Michael Rausch of North River Wealth Advisors.  We are an independent, fee-only financial planning and investment management firm located in Pittsburgh, PA servicing clients locally and across the country.  To learn more, contact us here.

This content is developed by North River Wealth Advisors from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.