This week's response comes from:

Cathy Pareto

Catherina Pareto is the Marketing Director of Investor Solutions, Inc., a fee-only registered investment advisor with over $85 million in assets. Cathy has a BBA in Finance from Florida International University and is currently enrolled in the College for Financial Planning curriculum in preparation for the Certified Financial Planner (CFP) Certification Examination. She can be reached via email at Cathy@investorsolutions.com or via the www.investorsolutions.com website.

Should I invest in index or managed funds for my retirement account?

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Should I invest in index or managed funds for my retirement account?

from Stephen

Q: In a 403b retirement account that I intend to contribute into for the next 5-10yrs., do you believe it would be more beneficial to invest in index funds or to invest in various five-star funds with excellent past records?

A: (Cathy) 

Thank your for submitting your question to MFI!

Your question should really be divided into two distinct (yet, interrelated replies):

1. choosing active vs. index funds
2. reliability of Morningstar ratings as a guide for future success

Index Funds

The debate between active vs. passive has been going on since index funds hit the scene in the mid seventies. Active managers dominate the mutual fund universe by their sheer quantity. They trip all over themselves, with the help of huge marketing budgets, to get their hands on your money. They promise you the world, convinced that they will deliver to you above market returns. Yet, strong academic support has proven that 80% of them fail to consistently beat, let alone match their benchmark.

Indexing provides the most effective and economical method of capturing the world’s market performance, and is the benchmark against which other investment styles must be measured. Index funds are the most reliable way to capitalize on this. An investor must have a compelling reason to abandon this simple reliable and effective technique.

The guidelines for selecting any fund should be:

Low Costs - Never ever, ever, ever pay a load! Only buy true no load funds and look for low expense ratios (mutual fund management fees). Whether they're front end loads, back end loads, etc.; a load sliced any other way is still a commission you should not have to pay. For every "good" load fund available out there, you can probably find 10 "good" no load funds.

Low Turnover - Turnover in a mutual fund translates into taxes for you, the shareholder. Choose a fund that has a low amount of turnover. The less turnover, the less tax headache. High turnover also results in hidden costs due to the bid/ask spreads of the stocks and possible market impact. It's generally a bad thing.

Diversification - choose a fund that has a large representation for a particular asset class. A fund that holds 200 companies has a better diversification benefit than a fund with 50 companies. Also, don't consider a fund that places large bets on any particular sector; concentrated positions are risky. Be sure to diversify your portfolio with funds that represent different asset classes. It makes no sense to buy four funds that all represent the same class of companies (i.e.. U.S. Large Companies). Split up your pie (i.e.. domestic large company fund, small company fund, large value, small value, international fund, etc.)

Passive Investing Strategy - Whenever and wherever possible, choose a fund that is passively managed. Fund managers trip all over themselves trying to find ways to beat the market (in most cases the S&P500). There is insufficient evidence to support that timing markets on a consistent basis is a winning long term investment strategy. If you can't beat 'em, join 'em ... just buy the market itself.

Little Idle Cash - Be careful during your screening process to weed out funds that sit on a large pot of cash. There should be as little cash as possible; uninvested cash is a drag on performance and a waste of your money.

Style drift - Sometimes the fund's name can be a little deceiving. You may think that you're investing in a small company fund because the name would so indicate it. However, many fund managers arbitrarily choose to invest outside their given "style" (i.e.. large/small, value, growth). The end result for you may be a lopsided portfolio and an asset allocation you did not plan on.

An index fund satisfies all of the above requirements. If you're looking for low cost, low turnover, low taxes, low fees, focused investing, and diversification, just buy the index.

Five Star Ratings

A little information can be very dangerous! The Morningstar rating is (unfortunately) the most used, yet most misunderstood gauge of a fund's ability. I talk to so many investors that base their investment decisions on the ubiquitous Morningstar rating system. They load up on five star funds and two years later end up scratching their heads, wondering what happened to their capital value, while their five star fund gets downgraded to one star.

The Morningstar rating system glorifies funds with the best recent performance, for a given amount of risk. Food for thought: how much of that performance was due to the manager's skill and how much of that was based on pure asset class/sector/market return?

You've heard this before and you'll hear it again ... past performance does not guarantee future performance. Never ever buy a mutual fund because of it's track record. Instead, use the measures discussed above.

Important Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

Lastly, the questions and responses set forth here are for general informational purposes only and are not intended to substitute for performing your own independent research or contacting your financial or legal professional before making any investment decisions. We make no guarantees as to the performance of any investment strategy you choose and are not responsible for any losses you might incur.