Are Index Funds the Best Way to Invest in All Markets at All Times? We Think Not

Many people, even those with sizeable wealth, do their investing solely through index funds or ETFs (Exchange-Traded Funds). There are some real benefits to doing that — returns that track the market averages, lower fund costs, and lower taxes along the way. So what’s the problem?

In a white paper I am working on now, I fully explore the pros and cons of using index funds, which fall under the category of passive investing vehicles. And I also delve into the pros and cons of actively managed funds, in which managers buy whatever they think has the highest return potential in their area of expertise. At LNWM, we do not think it is wise to use only index funds or only actively managed funds. That is what we call a false choice. We firmly believe that using both types of funds in a portfolio  — selectively and judiciously — can provide better results over a full market cycle.

LNWM’s Whole Portfolio Approach: Passive and Active 
At LNWM, we use both index funds and actively managed funds in client portfolios, depending on the market outlook and characteristics.Typically, we use index funds for exposure to large US stocks, given that this is a more price-efficient market than other assets classes (foreign stocks, etc.). That said, there are times when actively managed funds can make sense here. During times of higher market volatility and/ or falling prices, a top active manager in US large-cap equities is more likely to outperform the S&P 500.

By contrast, we typically use actively managed funds to invest in US small stocks as well as foreign equities, especially in emerging markets. These markets are much less efficient when it comes to pricing and usually entail more risk. Astute managers can take advantage of pricing discrepancies so that returns compensate for the higher fees they charge (relative to an index) as well as the potentially higher taxes on trading gains. If an actively managed fund is not likely to outperform its benchmark index over a full market cycle, after fees and taxes are taken in account, we stay away.

Finally, the alternative assets within our client portfolios – mostly hedge funds and private equity – are by definition all actively managed funds. Our aim in using alternative assets is to lower risk without greatly sacrificing return. To do that, we want our alternative asset managers to invest in a way that veers from the market averages as much as possible. So when markets fall, our alternative assets have a chance to rise and offset some of the losses in the traditional assets (stocks, bonds, real estate).