Index funds are growing so fast that some pundits fear the financial system someday will break down when no one pays attention to stock prices. But thatâ€™s not going to happen, so donâ€™t worry about it and keep indexing. Continue below to find out more.
Investors use index investing to replicate the performance of a specific index
Indexing is still by far the best way to invest in the broad U.S. stock market. But in certain foreign markets and industries, active management wins.
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Indexing works more reliably in large, developed markets. From 2005 to 2015, just 18 percent of actively managed U.S. large-company stock funds equaled or beat the Standard & Poor’s 500-stock index, according to S&P Dow Jones Indices.
Actively managed midsize and small-company stock funds, in theory, should do better because those markets are a bit less efficient, but they did worse. Only 12 percent of those funds outpaced their respective indexes over the same period, according to Kiplinger.com.
So why not just choose one or more of those outperformers? Past performance does not predict future performance. A top fund in one decade may be among the worst in the next decade.
Index funds have the big advantage of minuscule expenses. The efficiency of major markets is another big hurdle. As more and more information becomes widely available and active-management fees remain high, it is becoming even more difficult for active managers to outperform index funds.
I also recommend index funds for the bulk of investments in other developed markets: Western Europe, Japan and Australia.
Use active management for emerging markets, REITS and natural resources
Perhaps surprisingly for an advocate of indexing, I recommend putting about 40 percent of your equity portfolio in actively managed funds. In emerging markets and certain industries, active management can work.
Emerging markets—Latin America and Asia (except Japan)—do not have highly efficient, transparent stock markets.
Emerging market indexes often include weak or struggling companies that skilled portfolio managers can identify and avoid. They have a decent chance of outperforming and earning their fees.
Lack of transparency means managers can find and use nonpublic information to get an edge when deciding which stocks to buy and sell. An astute manager can scoop up bargains and avoid duds.
I also use actively managed funds for investing in global REITS and natural resources stocks. A lot of international real estate opportunities are in Asia, where there is inefficiency.
Natural resources commodity prices can be very volatile. I like having a manager who has the flexibility to add or subtract exposure to different companies as commodities fluctuate.
Stay flexible. Neither indexing nor active management is set in stone as the best strategy forever.
I regularly revisit our decisions to use active or passive strategies for each asset class, and we’ve made some readjustments in the last few years. I want to make sure our recommendations are still appropriate in the current market environment.
Paul Jacobs, Certified Financial Planner (CFP®), is chief investment officer of Palisades Hudson Financial Group, based in its Atlanta office.
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