Why Index Funds Still Make Sense

Low fees and broad diversification matter--especially in this market.

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It's an age-old investing debate: Are index funds better than actively managed funds? There are pros and cons for each: Indexing--a form of passive investing--means low turnover among holdings. That leads to lower taxes. Index funds are also dirt cheap compared with active funds. And in a market like this, every penny you give up in fees counts.

On the active front, managers have the ability to weed out stocks they think are more attractive than others. They can also shift their portfolio to take advantage of market conditions. For example, managers might keep a portion of the portfolio in cash when the market's jumpy.

Many financial advisers I talk with use both active and index funds in clients' portfolios. For example, Jeff Layman, CIO of BKD Wealth Advisors in Springfield, Mo., uses index funds for wide diversification and tax management, then mixes in active funds as "satellite" investments, which can contribute to diversification and add value if the manager is skilled.

In a recent interview with Steve Forbes, Morningstar's managing director of research, Don Phillips, weighed in:

...I'm a big fan of index funds. I put a lot of my own money into index funds, and interestingly the index funds in our star-rating system consistently show up as four-star and occasionally even five-star investments. So they score very well in our system because it looks again at long-term performance and at cost.

So indexes are great building blocks for investors. But there is the possibility that you can do better than the market. And there are certain funds that are more specialized and may fit a certain niche in an investor's portfolio. But I think for most investors, starting with a broad-based index fund as the core of their portfolio makes all the sense in the world.

For those interested, here are some pointers from Morningstar on picking the best index fund.