There are a lot of buzzy terms when it comes to 401(k)s, and one that’s particularly worthy of the attention are index funds. Why? Because index funds are one of the easiest and most effective things to add to your retirement arsenal. They also happen to be way too scarce in 401(k) plans for some not so good reasons.
What’s an index fund?
Let’s start off with the basics. An index fund is a type of hands-off fund that tracks a particular benchmark financial index, such as the S&P 500, Nasdaq or the Dow Jones Industrial Average. In fact, it’s designed to mimic the performance of these market indexes. It’s a passive way to invest in the markets—and it’s this passivity that makes it a fantastic, low-cost alternative to actively managed funds that are offered through most 401(k)s. Exchange-Traded Funds (ETFs) or Index mutual funds are the most common methods for folks to invest in an index fund.
Why costs matter in investing?
Each dollar going towards investment expenses is one less dollar staying in the markets to invest and grow over time. In fact, a difference of 1% in fund expenses can literally cost you hundreds of thousands of dollars over a 40-year career. The fund expense ratio is how you typically get a sense of the cost or drag on your investment. Any fund with an expense ratio over 1% is a red flag that you are paying too much. It is really tough to beat the markets, and index funds are the closest thing to buying the market. Now think about a fund manager trying to beat the market and has to overcome all the added costs to try to figure out market moves. Do you think many do? (Hint: history is on the side of the low expense one).
Why do actively managed funds costs more than index funds?
Actively managed funds typically have more costs associated with them than index funds for several reasons:
- there’s a bunch of research that needs to be done to try and forecast market or sector moves
- there’s typically more costs of trading stocks and bonds within the fund as they switch tactics
- there are the added manpower hours to run an actively managed fund
- there are marketing and other costs that are charged via 12b-1 fees and can even include front- or back-end loads (if you see loads in a fund, we strongly suggest you avoid it)
The list goes on, as the costs can too. And with each extra dollar of expense incurred, the fund still has to overcome these expenses to outperform its benchmark index (usually the success measure of actively managed funds). But when you have index funds, most of these costs are eliminated and why the fund expense ratio is often much lower. Guess who ultimately reaps the benefit of less costs? You.
History sides with index funds for better long-term performance
So, don’t get us wrong, these higher expenses might be worth it if evidence showed that actively managed funds were consistently outperforming the indexes. But that’s not usually the case. In fact, history has sided with index funds. Across major asset categories, the benchmark indexes over the last five years have beaten 82% to 95% of actively managed mutual funds across major equity asset classes:
There are very few managers that have beaten their benchmark over a 5-year track and the list gets smaller and smaller over a 10- or 15-year time horizon. We’re not soothsayers over here and can’t predict the future, but those facts are pretty darn compelling.
Do know that history is no guarantee of future performance. Markets, companies, governments, and economies are constantly changing. However, we do try to learn from history and apply it as best we can.
Takeaway: keep fund expenses low so more money stays invested and working for you. This is something we strongly believe is the better way for long-term investing.
Why are index funds scarce in 401(k) plans?
There are several reasons why many 401(k) providers offer very few index funds in their investment line-ups. Probably the biggest reason is that the provider that sold you your 401(k) plan and/or those that service your plan are often paid through the fund expense ratios. You may have heard of 12b-1 fee, Sub-TA, or other fund fees. These will usually be bundled into the fund expense ratio. Well, index funds don’t have 12b-1, Sub-TA or other pass through fees that are common in actively managed mutual funds and insurance products.
If a provider allows more than a few index funds in your 401(k) roster, they make less money. Other reasons include that many fund providers are also 401(k) providers, and they would like to have their funds in your plan. While they may want to make sure the asset class is right for retirement investing, they’d probably also like to earn more money so a higher expense fund might find its way into the line-up. Now think if they moved all their clients to index-based 401(k) plans en masse. That simply would not be good for their bottom line.
Join the groundswell for index-based 401(k) plan for a healthier retirement!
When you’re evaluating what 401(k) plan to trust with your retirement, look to see how many index funds are included. If you see even three or four, you’re ahead of the game. However, that’s not good enough. Here at ShareBuilder 401k, we care so much about keeping things low expense to help Americans save that we think 100% of your funds should be in index funds (the Cash or Money Market option is the exception). In fact, we pioneered the all-ETF 401(k) plan in 2005 and have never looked back. After all, if index funds historically performed better than higher cost actively managed funds, why not build a solid, diversified portfolio for less? That just means more money stays invested in your 401(k) today and ongoing to better serve your retirement tomorrow.