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TORONTO (GlobeinvestorGOLD) — When it comes to protecting yourself from risk, there are some obvious guidelines to keep in mind: wear a helmet when rollerblading, don't play with nitroglycerin, avoid sharks while scuba-diving, that sort of thing.
When it comes to protecting your investment portfolio from risk, one of the best ways is to avoid putting too much of it in one particular stock, bond or commodity — or even into one group of similar investments, such as oil, technology or income trusts. In other words, diversification is always a good thing. And one of the best tools for both diversification and protection from risk is the index fund.
To many investors, index funds seem like kind of a cop out. After all, if the best you're going to get from your investment is the same performance as a stock or bond index — since that is what index funds produce by definition — isn't that setting your sights a little low?
Wouldn't it be better to invest in a so-called "actively managed" fund, where the manager moves things around and actively searches for the best spots to find value? Isn't that how you get superior returns out of your portfolio?
Well, no — at least, not always. In fact, while actively managed funds can outperform various stock indexes for short periods, research shows that over the intermediate to long term, index funds do at least as well when it comes to preserving your investment, and in many cases do substantially better than managed funds. Several studies have shown that index funds outperform more than 75 per cent of managed funds. As one comedian put it: "I'm not concerned about a return on my money — I'm worried about a return of my money." And index funds do a pretty good job of that.
In many cases, the actively managed funds that outperform an index wind up doing poorly in future periods, for a number of reasons. For one thing, there's the law of averages, which makes it increasingly unlikely that a top-performing fund will continue to beat the index year after year. Managers also change funds, which can alter the winning formula. And winning funds also tend to attract a lot of money, which makes them so large that it is almost impossible to continue producing outsized returns.
There are a couple of other benefits to index funds. Since they don't make as many trades as managed funds, they are usually more tax efficient, since investors don't pay as much in capital gains. They are also cheaper in the sense that their fees are lower, because there is less management expertise to pay for. And those lower charges increase the chances that they will outperform managed funds on a real-return basis.
That's not to say index funds are perfect, or that investors should pour all their money into them. Because they effectively mirror the composition of a particular stock index, such as the Standard & Poor's 500, their performance relies on the choices that are made by the arbiters of the index. As a result, many active fund managers would argue that stock indexes can suffer from the same kinds of misconceptions and incorrect assumptions as any other investment — favouring certain segments of the market or types of investment — whereas a good actively managed fund would not.
But just as a wise investor should balance their portfolio among many different asset classes, they should also find a balance between betting that an active manager can beat the odds and outperform an index, and betting that an index fund can preserve some of their capital in as low-risk a way as possible. The latter is a much safer bet. It may not be as exciting as playing the market, but excitement is no substitute for a healthy portfolio.
Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.