Dan Solin helps us to understand first of all why index funds are better than actively traded funds. Then he goes on to explain why there is an even better way to invest than index funds. We call it institutional funds, he calls it passive asset class investing.
Here is part of the article he recently wrote.
“I am a proponent of evidence-based investing. The evidence is compelling that investors have higher expected returns when they reject actively managed funds and invest in a globally diversified portfolio of low-management-fee index funds, in an asset allocation appropriate for them.
While appropriate index investing may be a superior strategy to buying individual stocks or investing in actively managed mutual funds, you may also want to consider the benefit of using passive asset class funds.
Index funds are “passively managed” because the fund manager seeks to “passively” track a benchmark index, like the S&P 500 index. Passively managed funds have many of the benefits of index funds. They are typically low cost, have low turnover and are tax efficient. However, the manager of a passive asset class fund has certain flexibilities denied to the manager of a comparable index fund, such as:
Flexibility When to Buy and Sell Stocks
An index fund buys and sells stocks when they enter and leave the index. A passive asset class fund has the ability to reduce turnover and increase tax efficiency by establishing a range that permits it to hold a stock even if it drops out of the index.
Flexibility in Stock Selection
A passive asset class fund can establish a screen to exclude categories of stocks with historically poor returns, like initial public offering stocks. An index fund manager does not have this flexibility.
Use of Block Trading Techniques
There are sophisticated trading techniques a small cap, passive asset class manager can use that are not options for index fund managers. Because the market for these stocks is relatively small, and dumping a large block can affect the stock price, a passive asset class fund may be able to buy these stocks at a favorable price from a seller who has an urgent need to liquidate holdings.
Tax Efficiency
Both index funds and passive asset class funds are tax efficient. However, passive asset class funds can engage in additional strategies that can make them even more efficient. These strategies include:
• Avoiding intentional short-term gains
• Selling stocks with big losses and tax harvesting those losses
• Avoiding the purchase of stocks just before their ex-dividend date
Passive asset class funds can also focus on minimizing dividends, in an effort to improve after-tax returns.
If you are an investor who believes in evidence-based investing, you should not limit your options to index funds.”
Solin, Dan. “Solving the Mystery of Passive Asset Class Investing.” The Huffington Post. TheHuffingtonPost.com, 21 Jan. 2014. Web. 23 Jan. 2014.