Section IV - Lesson 6
Selecting A 500 Index Fund As Your Ideal Investment
In the previous section, when we were selecting an investment for your 401k, we could only pick from the items that were available in your particular plan. It was quite likely that there was not an S&P 500 Index fund available, and that the best available fund was a managed stock fund. This is not ideal, but it isn’t necessarily all that bad. There are many very decent managed stock funds, and considering all the other benefits of your 401(k) you should still make out fairly well.
But with your regular money account, we can choose whatever investment we want, and whatever mutual fund company we want. We are not restricted in any way, and we don't have to settle for a managed mutual fund.
There are several disadvantages of a managed fund, as compared to an index fund, in a regular taxable investment account. For openers, a managed fund will cost you about 2% per year in management and transaction fees that you almost completely avoid with an index fund. So if both funds enjoy a gross return of 10.5% during a given year, the net return of the managed fund may be only 8.5%, while the net return of the index fund is 10.3%,
Another disadvantage of the managed mutual fund is stock turnover as the manager buys and sells securities in his effort to outperform the market. Turnover creates the previously mentioned transaction fees which are inconsequential in an index fund because there is virtually no turnover.
Turnover also creates taxable capital gains distributions, which, of course, are not a factor in your 401(k) but would be a concern if you go with an actively managed fund in your regular money account. These capital gains must be reported to the IRS every year, and taxes paid on them, even though you received no money and let them reinvest. They call this "phantom income."
So always prefer to own a market index fund if you have a choice in the matter, as you do with your regular money. And prefer an S&P 500 Index fund or a Total Stock Market Index fund as the absolutely perfect investment for your needs. You enjoy the broadest possible diversification, and you participate in the growth of the entire U. S. economy.
You also enjoy the lowest possible costs, and these savings translate to the highest possible overall net returns. These funds are no-load when you buy and when you sell, and generally carry an expense ratio of only about two-tenths of 1%, which is among the lowest in the industry. You’ll consistently outperform even the best of managed funds whose expense ratios are generally quite a bit more than 1%.
Market index funds are not only cost efficient, but also tax efficient. The virtually non-existent portfolio turnover results in almost no capital gains distributions to report on your annual tax return.
On top of everything else, these funds are easy to understand, easy to follow, and lend themselves perfectly to dollar cost averaging and the type of regular monthly investing that we want to do.
As you set up your regular money account and select a mutual fund company to invest with, you’ll be happy to find that just about all of the well known “families” offer at least one market index fund that mimics the S&P 500 Index. A word of caution, however, is in order here.
First of all, having the fund you want is only part of the reason for picking a particular fund company for your regular account. You’ll also want to know that this company is easy to reach, easy to transact business with, and quick to respond to customer service issues.
Keep in mind that you definitely won’t want to be moving your money from one company to another in the future, so take care to choose your company very carefully. To move your regular money account from one place to another would raise tax consequences and lump-sum investment problems. Take time to pick your company like you’d pick a business partner, because this, indeed, is what you’re doing.
Secondly, beware of non-genuine index funds! All S&P 500 Index funds are not created equal, even though you’d expect that this would be the case. There are companies that offer what they call “enhanced” S&P 500 Index funds, which instead of trying to mimic or replicate the actual index, supposedly try to “improve” upon the index by investing more heavily or lightly than they should in various sectors of the index, on the presumption that they can outperform the index. They then charge a higher fee for managing your index fund!
Well, guess what? You no longer have an index fund. You have a managed fund, because the manager’s going to buy and sell securities in an effort to do better than the index itself. You also have annual management fees, and turnover, and transaction fees, and higher costs. “Enhancing” the product defeats the entire purpose of buying the index in the first place. People have bought more than $400 billion worth of the real product over the years, and there has to be a reason for this popularity. Insist on the genuine product!
Lastly, be conscious of costs. Once you have identified two or three companies that seem to have what you want, take time to compare the expense ratios, and other cost information. If all two or three of your candidates offer true S&P 500 Index funds, the one who operates with the lowest costs will likely perform the best for you.
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