- Indexed investments try to replicate the returns of the overall market
- Low cost and disillusionment with active managers may help explain the rise of indexed investing
- The drawbacks of indexed investing may undermine effective retirement savings
Anyone approaching retirement age is old enough to remember the once-popular slogan for Greyhound buses: "Leave the driving to us."
Younger adults, on the other hand, came of age in the era of cars that brake themselves, parallel park themselves, and may soon drive themselves too.
The appeal of shedding the responsibility of driving may also help explain another major trend shift -- a significant decline in more active investment approaches in favor of indexed investments. Indexed investments have, in recent years, attracted hundreds of billions of dollars at the expense of more active investment approaches. In fact, this shift to a more hands-off approach to investing has become so popular that, if you are not already part of it, you are probably at least considering it.
But before you take your hands off the wheel completely, there are some things you should know about indexed investing. It may not always meet the needs of your retirement savings.
What is indexed investing and why is it so popular?
Indexed investing, also known as "passive investing," is an approach that does not try to pick and choose individual investments in an attempt to beat the stock market. Instead, it tries to hold a representative cross-section of holdings in an attempt to replicate the returns of the market.
The popularity of this approach can be explained by two things:
- First, it is cheap. The average fee paid on passive U.S. equity funds amounts to just 11 cents annually for every $100 invested. The average fee on active U.S. equity funds is nearly seven times as expensive, at 73 cents a year for $100 invested.
- The second reason passive investing has become so popular is that most active managers fail to beat the market. This reality is simply a numbers game.
In aggregate, the pool of all active investors roughly represents the full range of holdings of the stock market. Over time, then, you would expect there to be more or less as many winners as losers -- some beat the market and some trail it. However, when you factor in the fees that active managers charge, it raises the bar such that relatively few are able to beat the market by enough to make up for those fees.
Frustration with the inability of most active managers to consistently beat the market has driven investors into the arms of indexed investment approaches. For over a decade now, passive investment vehicles have been attracting investor dollars while active ones have seen net outflows of money. In 2017, for example, a net total of over $220 billion flowed in to passive U.S. equity funds, while over $207 billion flowed out of U.S. equity funds, according to Morningstar Research.
6 ways indexed investing could fail your retirement savings
Low cost and disillusionment with active managers may be valid reasons why money is flowing into indexed investments, but indexing is not a perfect solution for your retirement savings. Here are some ways it may let you down:
- A key choice is still up to you -- which index?
Large mutual fund providers offer over a dozen different types of index funds, each representing a different financial market or subset of a market. It is all well and good to decide you just want to go along with the market, but which one? Deciding that leaves you with an active choice to make.
- Asset allocation is still a key decision
The proportion of stocks, bonds, liquid assets and international securities will have a significant impact on your investment returns. With index funds often slicing investments into narrow market segments, how will you decide on the right allocation of those segments?
- You will have to handle re-balancing your investments
Once you set an asset mix, differing asset class returns will start to move that mix out of alignment. With passive investments, it will be up to you to decide when and how to move things back into line.
- Low-cost funds may not eliminate the expense factor
401(k) platforms and IRA custodians may layer structural fees on top of the underlying mutual fund fees; so don't think that, just because you have indexed investments, you don't have to keep an eye on fees.
- As your circumstances change, your investment needs change
As you get ready for retirement, it may be appropriate to start shifting to a more conservative investment mix. While some target-date funds will do this for you automatically, a portfolio of narrowly defined indexed funds won't.
- Market conditions can change radically
Some newer asset classes might not come close to replicating their past rates of return as they mature and valuations rise. Also, sometimes fundamental economic conditions create long-term headwinds or tailwinds for certain types of assets. That's especially important to think about with the economy shifting from years of a low-interest-rate environment to a rising-rate environment.
Whether you favor the active or the passive side of the investing debate, you would do well to take some lessons from the opposing camp. Active investors should take a cue from their passive counterparts and consider price in their evaluation of investment managers, along with long-term track record and the depth and stability of the management team.
As for passive investors, keep in mind that there are still times when active decisions are required. If you don't have an active manager for your retirement savings, then you need to step up to the responsibility of making those decisions yourself.
More resources for planning retirement savings:
How much money do you need to retire? Use our retirement calculator
More on investing strategies:
Starting to invest? Read: 8 costly investment mistakes to avoid
Best practices for rational investing - Investing: from fear to greed
Ready to learn more? Read: Why you need to re-balance your investments - today