When An Index May Not Be The Best Choice

piggy bank on emptyMany of our clients are savvy investors.  They do their reading, they realize the importance of low expenses, and they naturally ask us why we don’t always use an index or a passive investment vehicle for their accounts.

What they read in the popular financial media seems to suggest that cheaper is always better, right?

Well, not exactly.  Cheap is great.  But using a low-cost index or ETF isn’t always the right answer.  So while we do invest in indexes and ETFs and other “passive” investments for client portfolios, we also use a selection of actively managed funds. (Not sure of the difference? See the bottom of the page for a comparison of “active” and “passive” approaches).

Here’s a powerful example showing why an index may not always be the best choice for you.

Hypothetical couple #1, John and Barbara, retired January 1, 2000, undoubtedly one of the worst times in recent history to retire, thanks to a bursting tech bubble and broad market decline.

John and Barbara started out with $1,000,000 in their retirement account, which they invested in an equity income-type stock fund, managed by a long-standing and experienced fund family, noted for its low risk and value approach. Each year, they’ve withdrawn $60,000, or 6% of the initial account value, to spend (by the way, that’s above the 4% withdrawal rate we normally recommend). Over the years, that’s added up to total withdrawals of $815,000.  But at the end of July 2013, despite all those withdrawals, their retirement account balance is just shy of $1.6 million, significantly more than they originally started with.

Their friends Doug and Sally, hypothetical couple #2, invested at the exact same time, but they haven’t been quite as lucky. They put the same $1,000,000 of retirement money into the S&P 500 index, believing that investing in a low-cost index fund was the way to go.  They’ve taken out the same $60,000 per year, for an identical total withdrawal of $815,000.  Unfortunately, taking out such a sizable withdrawal year-after-year during the infamous “lost decade” has taken a toll on their portfolio.  They now have less than $135,000 remaining in their account, meaning they will run out of money far too early.

So what went wrong?

Don’t get us wrong. The S&P 500 can be a great investment.

But that doesn’t mean it, or any other index or ETF, is the right investment for every one or every situation.

Sometimes an index or ETF is the right solution; other times you desperately need the experienced and hands-on guidance of an active manager to control risk and avoid potential landmines.  That’s especially true for retirees who have entered the often treacherous “withdrawal” stage, where drawing periodic income from the portfolio changes the dynamics of risk and return. 

The Takeaway: Your fee-only portfolio manager never receives investment commissions, and has every reason to steer you to the best possible investments for your personal situation. After all, the better you do, the better he or she does. Low-cost index and ETF products definitely have a place in the advisor toolbox, but as every handyman knows, it’s important to be well-stocked with a range of tools, so you can always apply the right one to the task at hand.


(For our readers, an “actively” managed fund uses a portfolio manager to pick the best stocks and bonds. A “passive” fund doesn’t usually try to pick the best investments; it simply mirrors the stocks or bonds in the index it tracks, and weights them proportionally. For example, an actively managed large cap growth fund might select the big growth stocks it thinks will perform the best, or have the highest dividends, or offer the best risk-adjusted returns.  A passive fund might offer all 500 stocks found in the S&P 500 index, or a representative sampling of tech stocks, or small companies, depending on its investment mandate. One approach thinks smart managers can add value by picking the best investments, while the other approach believes it’s not possible to consistently beat “the market” after fees, so tries instead to mirror the market but on a smaller scale.  This is of course a simplistic explanation – leaving out all the shades of grey – but gives you the main idea).

(Calculations were run using Morningstar Hypothetical Illustrations).


About Mari Adam

Mari Adam, Certified Financial Planner™ has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!

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