Monday, November 19, 2007

Fund Managers Running Scared

The investing strategy of indexing is a major threat to the mutual fund industry. (See some of my previous posts for an explanation of indexing, examples, and how to get into an index.) When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in a mutual fund with a Management Expense Ratio (MER) of 1% pays $1000 per year in fees. Up that to the $500,000 you’re hoping to have one day and a 2% MER, and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing.

Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing. After all, nothing is completely good or completely bad. In the rest of this post and some following posts, I will go through the main points in the case against indexing and give my thoughts.

Argument #1: Some index funds aren’t very diversified.

This is true to a point. For example the Vanguard Energy ETF is an exchange-traded fund that tracks an index of energy stocks. This fund is for investors who like energy stocks, not for those looking for diversification. The implication of this criticism is that all index funds lack diversification, and that you need an active portfolio manager to be safe from having all your eggs in one basket. This is simply not true.

S&P 500 index funds invest in 500 of the biggest U.S. companies. If you are concerned owning only large companies, then there is the Vanguard Total Market ETF that holds 1200 of the largest U.S. companies plus a representative sample of the remaining stocks. If you are concerned with owning only U.S. companies, then there are international index funds. Some of your money could go into low cost bond funds as well, or you could buy a bond directly. There is no reason to pay high management fees to get diversification.

In the coming posts, I’ll look at some of the other arguments against indexing.

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