Passive Investing with an Index Fund

Passive investing with an index fund has both advantages and drawbacks. While some studies have suggested that over the long-term, passive investment is more successful than active management. However, because of our recent financial crisis, there is now doubt where passive index funds are considered. Also, index funds are one of the options you can use for passive investing. The fee structures of most passive vehicles are attractive, but without satisfactory returns, low fees are irrelevant.

Passive Versus Active Investment

There are two primary approaches you can use for investing in the stock market, passive investing and active management. With passive investing, you buy an investment vehicle like an index fund or an exchange-traded fund (ETF) that tracks a major equity index. Historically, the stock market as measured by the S&P 500 has returned about ten percent per year, over the long-run. Investment scholars have suggested that you will never do better by trying to beat the market.

The other approach that you can take is active management, either by selecting specific stocks yourself or by hiring a money manager. This approach is based on the belief that by making active decisions about individual stocks, you can achieve better returns. A factor that you should consider is that active management tends to cost more on a fee basis, so both approaches should be considered after fees.

An Index Fund Versus an ETF

Over the past decade, ETFs have been growing in popularity and acceptance. An ETF, like an index fund, tracks one of the major equity indexes in an attempt to provide you with the same return. Unlike an index fund, however, an ETF does not mark its asset to market at the end of the year. This procedure that must be performed by a mutual fund creates a taxable event for investors. If you hold the position for over a year, any gains are taxed as capital gains, rather than ordinary income. The capital gains tax rate is much lower for almost all individuals.

In addition to the above benefits, ETFs are more liquid and can be actively traded if necessary. The fee structures of the two products are equal in the best cases, and favor buying an ETF in other cases. Essentially, you get the same return by buying an ETF, but pay less tax and have greater flexibility.

The Right Choice

Despite the fact that most of the major equity indexes finished the last decade at the same level as they started it, over the long-term, you will benefit by having some asset passively invested. With low fees, controlled risk, and no need to monitor the position regularly, a passive investment approach has advantages. Within the context of passive investing, ETFs give you several advantages over index funds and are often a better choice. Overall, therefore, you should make an evaluation as to what portion of your portfolio you wish to commit to passive investing and then buy an ETF.

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