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Index funds are aggressively promoted by mutual fund sellers like Vanguard as the lowest cost method of investing. This is unfortunate. While index funds certainly have lower cost compared with the vast majority of mutual funds, index fund costs are not small in absolute terms. Assuming 10 percent annual return on a $1 million portfolio, even index funds with a seemingly low 0.2 percent expense ratio would cost an investor $46,665 in fees over 10 years, arguably no trifling sum for the privilege of guaranteed under-performance of the market index by 0.2 percent a year. Is there a better way to invest?

Why Index Funds

Index funds, like any mutual funds, are financial products, not direct investments in the same sense that bonds and stocks are. By owning the same thousands of stocks in the same proportion as the indices they track, index funds offer instant diversification and guarantee to match index returns, less fund expenses. We should own index funds, therefore, if we are unlikely to outperform the market return after accounting for expenses. In this regard, most small-cap stocks, some international stocks (especially those from emerging economies), and junk bonds are difficult to invest in inexpensively, which makes index funds appealing vehicles for investment in these particular securities.

High-quality bonds and stocks, in contrast, do not require nearly as many different issues for adequate diversification. Treasury bonds can be purchased directly from treasurydirect.gov without commissions. Since treasury bonds have no default risk, one treasury bond is as safe as a basket of hundreds of treasury bonds in a bond index fund. Moreover, individual investment grade bonds are actually safer than bond funds, because the former assures repayment of principal at maturity, but, the latter, which has no fixed maturity date, offers no such promise, as the price of the bond fund fluctuates inversely with the prevailing interest rate, deserting you to the whims of the market when you need to sell the bond fund. As for high-quality stocks, 5-15 different issues from diverse industries in similar weighting will provide adequate diversification against firm-specific risks.

Individual Stocks: Lower Costs = Higher Potential Returns

Today, with many online discount brokers charging commission as low as $2.50 to $10 a trade, investing directly in individual stocks is a lower-cost alternative to index funds. Assuming $3 per trade, and one trade per month, investing in individual stocks cost only $360 over 10 years, a tiny fraction of the $46,665 for an index fund with 0.2 percent expense ratio, on a $1,000,000 portfolio, assuming 10 percent annual return. If lower cost means higher return, as proponents of indexing would argue, investing in individual stocks is clearly the preferred approach, as long as the following rules are carefully observed:

1. Invest in high-quality stocks only. High quality stocks should have a solid record of consistently increasing dividends and earnings, low debt to equity, high interest coverage, high return on equity, and profit margins above industry average. It is helpful to check the bond rating as well, for, as a rule of thumb, one ought not to invest in the stock if the bond issue is unsafe. If the bond has an unacceptable risk of default, the risk of the stock can only be higher. Examples of high quality stocks include Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), 3M (NYSE:MMM), Wal-Mart (NYSE:WMT), and McDonald's (NYSE:MCD). See 9 Dow Stocks to Own For The Long Run for more details.

2. Use the lowest-cost online discount broker you can find. Consider commissions, fees, spreads, etc. Lower overall cost equals higher return.

3. Minimize trading. Aim not to trade more than once a month, to keep commissions low. Also, make sure to keep the commission low as a percentage of the size of your transaction. I recommend that commissions and fees account for no more than 0.1 percent of a trade, so if the commission is $3 per trade, your trade size should be at least $3000.

4. Buy and hold. There should only be three reasons to sell: you made a mistake in buying the stock in the first place, the fundamentals have significantly deteriorated permanently, or an unquestionably better opportunity presents itself, even after accounting for trading costs. Barring these uncommon reasons, it is best to hold onto the stocks you bought. If you kept your commission costs to 0.1 percent of your trade size, and you hold your position for 10 years, the cost drops to 0.01 percent per annum, much less than the 0.2 percent expense ratio typically charged by index funds.

5. Enroll in no-fee direct stock purchase plans ((DSPPs)) if available. For every stock that strikes your fancy, check online to see if a no fee direct stock purchase plan is offered. Aflac (NYSE:AFL), Procter & Gamble (NYSE:PG), and Exxon Mobil are examples of stocks offering such plans. Becton Dickinson (NYSE:BDX) charges $0.02 per $50, which is small and acceptable. Be careful, though, that many stocks offer DSPPs that charge high fees as much as 5 percent, so be discerning and avoid those plans. DSPPs allow you to invest a fixed amount of money, e.g. $100, each month, which employs dollar cost averaging and is quite similar to index fund investing, but much better, for DSPPs give you direct ownership in the underlying companies themselves. Most DSPPs have minimum monthly investment as low as $50. One can build a well-diversified portfolio consisting only of individual stocks using no or low fee DSPPs, such as the following:


StockSectorSource
Becton DickinsonHealthcarewww.computershare.com/investor
Procter & GambleConsumer Stapleshttp://www.pg.com/en_US/investors/shareholder_services/useful_forms.shtml
Exxon MobilEnergycomputershare.com/investor
AflacFinancialhttp://www.aflac.com/investors/shareholderservices/dripstockpurchase.aspx
Emerson Electric (NYSE:EMR)Technologyhttps://m1.melloninvestor.com/mellonone/index.jsp
Lockheed Martin (NYSE:LMT)Industrialcomputershare.com/investor
Pinnacle West (PNW)Utilitym1.melloninvestor.com/mellonone/index.jsp
McGraw Hill (MHP)Consumer Discretionarym1.melloninvestor.com/mellonone/index.jsp

While the example above of a stock portfolio consists of only 8 issues, these 8 issues are all large, prominent, and conservatively financed companies, each from a different sector, therefore providing sufficient diversification. This portfolio is arguably superior to investing in an index fund in many aspects, chief among which are:

1. Rock bottom fees. This saves a long-term investor tens of thousands of dollars, and the advantage of low fees only widens the longer the investor's investment horizon, due to compounding.

2. Direct stakes in companies. Companies offering direct stock purchase plans register their investors onto their records, which entitles you to attend and vote in shareholder meetings and reinvest all dividends automatically. Some companies offers many perks to registered shareholders as well. Index fund investors receive none of these benefits.

3. Possibility of beating the market's returns. While no portfolio of individual stocks is guaranteed to beat the market's returns, investors in individual stocks at least have a possibility of doing so. In stark contrast, index fund investors are virtually guaranteed to underperform the index return every year: by the expense ratio and other fund expenses charged. With essentially no fees, the DSPP portfolio is likely to do as least as well as the market, and, if the stocks are carefully chosen and the investor is disciplined to buy only at reasonable prices, the possibility of beating the market's returns are quite real.

Conclusion

The benefits of index funds are over-exaggerated. Index funds charge significant expenses, and they shine only in comparison with high-expense mutual funds, and in the earlier era of the stock market, when commissions were considerably higher than they are today. Investors today are truly blessed for the availability of low commissions and more and more companies offering low or no-fee direct stock purchase plans. For long-term investors today, the most sensible approach is not index funds, but a portfolio of individual stocks, purchased via direct stock investment plans, or in a disciplined manner aimed to contain commissions and fees, for, after all, lower fees are the royal road to higher returns.

Source: A Lower Cost, Higher Return Alternative To Index Funds