Don’t Be an Index Fund Zealot: It’s Fees that Matter

Many investors build a modern day version of The Berlin Wall between implementing strategies using index funds vs. those espousing active management. Like anything else, the answer lies somewhat in the middle. Acting as a zealot in either direction could result in many lost  investment opportunities.

Most don’t realize this but the “Godfather”of indexing, Jack Bogle, is not against active management. I can already hear the cries of “Heresy” from the legions of Bogleheads nationwide. Before lighting the fire for the burning stake, consider the facts.

When Mr. Bogle was asked if given the choice between a high-fee index fund and low-fee active fund, he did not hesitate with his answer. The fund with low fees is usually the best choice for investors.

As a matter of fact, his former company Vanguard, has more actively-managed funds than those based on indexes. In fact, many of their best funds are not of the indexed variety.   What Bogle is against are HIGH FEES. This, combined with index-hugging managers, makes active management a very poor choice for investors who choose to take this path.

Bogle has been quoted as saying, “There are perfectly reasonable alternative strategies for supplementing index funds.”

How does one use active funds? The first thing is pick low-cost products. Besides Vanguard, T. Rowe Price and USAA offer some quality options.

Second, make sure the manager does not trade excessively or replicate his index. The fund’s holdings should be vastly different than the S&P 500 if it is classified in the large-cap core category. If there is no real difference in security selection, you will be stuck with a glorified index fund at five times the cost!

It has been determined that 50% of all active funds fit into the closet indexing category!

Third, pick a category that is illiquid compared to the major indices. Foreign small stocks, along with micro-cap stocks, are categories worth venturing into when seeking a good active fund manager.  Though this will be a difficult task, you may find some value in more obscure asset classes.

Very few active managers beat the index in the popular large-cap U.S. stock sector over the long term, represented by the S&P 500. Determining which asset classes make the best case for active management is not an investor’s only dilemma.

A very important, yet overlooked, item is: Where should you place the actively managed funds? Many investors use their taxable accounts and find themselves with some nasty surprises when the tax man comes knocking at their door.

This is exactly what happened to the shareholders of The FPA Perennial Fund this year. The fund decided to change its investing strategy and therefore had to liquidate most of its holdings. Unfortunately for the investors, most of these holdings had large embedded capital gains.

If this position were held in a 401K, IRA, or any other tax-advantaged account, the issue would be a moot point. For those who held FPA Perennial in a taxable structure, it was anything but!

The fund made a capital gains distribution of an astonishing $39.67 a share, which was equivalent to 81.8% of its total asset base! Taxable account investors were now left with a new fund called FPA U.S. Value Fund and an unexpected huge tax bill.

For example, let’s assume the investor held 3,000 shares and was in the top tax bracket of 23.8% for capital gains. In this scenario, this unfortunate individual would owe over $28,000 in capital gains taxes. If the gains were short term, the tax bill would be over twice as much!

While some might say this person is wealthy and can afford the cost, that is not the point. The lesson is to avoid this potential problem by placing a fund like this in a tax- advantaged account.

Middle class investors could also find themselves in a precarious situation from this unforeseen tax event. If parents were looking to send their child to college in the near future, this surprise disbursement could negatively affect financial aid possibilities.

Older investors could experience a rise in their income-based Medicare premiums. This extra income could possibly prohibit a Roth IRA contribution or simply push someone into a higher tax bracket.

All of these nasty scenarios could have been avoided by simply understanding that active funds could have a large effect on taxable income if they are held in a taxable account.

Personally, I am not an extremist. I see too many things like the current beheadings in the Middle East; uncompromising political positions on social issues; and genocidal governments from the past that lead me to believe this attitude can get you into big trouble.

A core holding of index funds supplemented with low-cost actively managed  funds  can also be an excellent investment strategy.  If you decide to travel down this moderate path, make sure you focus on these items regarding your actively-managed component:

1. Make sure the actively-managed mutual funds are low cost.

2. Identify mangers who have long-term successful track records and follow a rules-based, not emotion-based, investment strategy. Factor-based investing would be a prime example of a sensible active strategy.

3 Fund managers should “eat their own cooking.” This means managers should have a significant portion of their own wealth in the funds they manage. If they don’t have confidence in their strategy, why should you?

4. Pick sectors that are not very liquid to get the most added-value and avoid index-hugging, expensive strategies.

5. Finally, make sure you protect yourself from unforeseen capital gains that you have no control over. Make sure these funds are not located in your taxable accounts.

If you cannot follow these rules then you are much better off owning low cost index ETFs for all of your holdings. You should entirely avoid managers who select individual stocks and bonds. This will  not make you a zealot.

In fact you will be following one of the most important rules for successful investing, knowing what you don’t know. The alternative would be paying a very high price for tuition with higher taxes and  lower returns.

Don’t dismiss active funds, just understand that the rules are different and more complicated than using a simple indexing strategy. Learning the rules can add to your overall returns.

Don’t be a zealot, but avoid being foolish with your hard-earned money. Moderation is not such a bad idea for everything you do. This includes the choice between active and passive funds in your investment portfolio.