Index Funds and Turnover Rates
Welcome to Your Money where we help you achieve your saving and retirement goals. We have three good questions today, two of which may help you invest your hard-earned money more efficiently. Kiley K. from St. Louis, MO writes:
Dear Investor Ed,
Why do many individuals use passively managed mutual funds, known as index funds, to save for retirement and other financial goals?
We’re all pretty familiar with mutual funds, right? These are companies that pool money from many investors and invest the money in stocks, bonds, or other securities.
Kiley’s question focuses on a particular type of mutual fund – index funds. These funds try to equal, not beat, the returns of a major index, such as the S&P 500.
Unlike an actively managed mutual fund, which picks and chooses investments based upon a fund manager’s research, an index fund typically tracks the holdings of a particular index through computer-programmed buying and selling.
Not surprisingly, the fees for index funds are generally are much lower than the fees for actively managed mutual funds.I think Kiley and other listeners might want to know the effect of these lower fees on their fund returns.
Over long periods of time, the impact of seemingly small differences in fees can really add up. Of course, everyone cares about the bottom line. When comparing similar mutual funds, lower fees can translate into better performance, according to researchers. In fact, most actively managed funds do not "beat the market" in any given year.
What about all those great returns I see in advertisements? Wouldn’t it make sense to pay just a little more for an actively managed fund to get those kinds of returns?
Studies show that very few actively managed funds, including those with impressive short term performance records, provide stronger-than-benchmark returns over long periods of time. Choosing a fund, of course, is a very personal decision. And remember that fees only are one important factor. Thanks for the question, Kiley.
Mike M. from Brooklyn, NY says he’s found a fund with low annual operating expenses that he thinks meets his investing goals. He wants to know whether he should also consider the fund’s turnover rate?
A fund’s portfolio turnover rate, which measures how often it buys and sells securities, is an important consideration, particularly if Mike is holding his investment in a taxable account.
A fund that frequently buys and sells securities may generate both higher trading costs (which will eat into returns) and capital gains taxes, potentially leaving a higher tax bill. In this case, Mike doesn’t tell us whether he’s investing a tax-advantaged account.
That’s right. If he’s investing in a taxable account, he should take a look at the difference between the before- and after-tax returns of the fund he’s considering. That information is available in the fund’s prospectus. The difference in pre-tax and after-tax returns – for funds with a high turnover rate, that is - can be quite striking.
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