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What to Do When Index Funds Are More Expensive

A reader writes in, asking:

“The problem my husband and I have encountered is that the index funds in his work retirement plan have high expenses, around 1%. The gap between index and non-index is small or non-existent for some asset categories. When confronted with such a situation, should you still go for the index fund, or is the non-index fund worth considering? What if the non-index fund is actually a little less expensive than the index fund, as is the case for one of our asset categories?”

My primary reason for (usually) preferring index funds is that:

  1. There’s been quite a bit of research over the years showing that funds with lower expense ratios tend to outperform funds with higher expense ratios, and
  2. Index funds tend to be less expensive than actively managed funds.

In other words, it’s (primarily) about costs. Given the choice between a) an active fund with a given expense ratio or b) an index fund with a higher expense ratio, I would usually be inclined to go with the lower-cost fund, even though it isn’t an index fund.

For instance, several of Vanguard’s actively managed bond funds (such as their Inflation-Protected Securities Fund, Treasuries funds, or tax-exempt bond funds) have lower expenses than many index funds in the same categories, and I would have absolutely no qualms about using the Vanguard actively managed fund rather than a more expensive index fund.

That said, there is one big concern about using an actively managed fund, even when it’s the lowest-cost option: manager risk. That is, because the manager has more leeway in how to invest an actively managed fund’s assets, there is a greater chance that the manager will use that leeway to do something stupid.

Fortunately, there are a few steps you can take to at least somewhat minimize the likelihood that you’ll be caught off guard by manager risk.

  1. To the extent possible, only use fund companies that you trust.
  2. Check the fund’s prospectus to see how much leeway the manager has in changing the fund’s asset allocation.
  3. Check to see whether there have been dramatic allocation changes in the past. One way to do this is to chart the fund’s performance against that of an index fund in the same asset class. If they have very closely tracked each other, it’s likely that the fund manager is not wildly changing the allocation over time.

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