Index Funds are The Hot Investment, But Why?

By Robert Plunkett

If you invest cautiously and you don’t employ an adviser, there is no good reason not to invest in index funds. These are mutual funds that buy the exact stocks that are included in a stock market index – such as the S&P 500. The idea is to match the index returns, not to try and beat it. 

The big question has always been, “which index funds to buy?” That’s a tough call since you have to change funds every time your goals change. 

Even if you dabble with investing it would be hard to miss the clamor over index funds. Everyone from Warren Buffett to an average broker has been praising their merits lately. Partly because they have outperformed many actively managed funds. But mostly because they have become cheap to buy and own thanks to a price war among the major fund companies. 

As the US economy limps along and money gets tight for personal investors, the major mutual fund companies are trying to attract new investment. But while a price war could be great, it isn’t always necessarily so.

Investors have been pouring money into these funds – called passive funds because they are not actively managed – because they offer low fees, tax benefits and ease of trading. And the big companies are cutting fees. The latest moves came from Charles Schwab and Fidelity Investments. Schwab lowered fees on its funds down to as little 0.03% , making them among the cheapest on the market, costing anywhere from $3 to $7 per $10,000 invested. Fidelity removed short-term trading fees for 75 funds and expanded the number of mutual fund transactions that are exempt from redemption fees. All this sounds good. But is it?

Redemption fees are charged to mutual fund customers who withdraw their money after a short period. These funds are paid back to the fund, which benefits the remaining shareholders. There are other benefits. The fees deter short-term trading and help fund managers by creating a more stable asset base so they can buy and sell when they feel prices are attractive. They can sell assets when the time is right and not because of short term redemptions.

EFTS for Short Term Investments

In making the decision to eliminate the fee, Fidelity concluded these passive funds are less likely to be targeted by short-term traders. They are now more interested in Electronically Traded Funds (EFTs) since they trade on exchanges like stocks. These low-cost ETFs are increasingly used by investors for short-term investing. The big fund companies are cutting fees to attract investment to their passive funds.

Last year, investors pulled $242.6 billion out of actively-managed U.S. stock mutual funds, according to Morningstar. Meanwhile stock ETFs pulled in nearly $100 billion in new money. Fund companies want to grab a share of that new money. Schwab is cutting its fees starting March 1. Fidelity, Vanguard, TD Ameritrade and E-Trade are reducing their commissions as well.

But the key in any mutual fund investment is performance – whether the fund matched or beat earnings in the market. Nothing beats fund performance research and lower fees are not the biggest factor to investing. Professionals insist people who are fully invested should not make asset changes based on lower fees. Saving in the short term, don’t necessarily payoff in the long term. Save the lower-fee funds for new investments.