14 Aug Are index funds a bad idea in shaky market?

Q. I’m invested in all index funds, some more aggressive than others. I do it because of the low expenses. Am I missing out on anything with actively managed funds, especially now that the market is higher and I’m expecting some kind of correction soon?
— Concerned

A. There’s no doubt that high expenses will eat into your returns, and that’s a major reason why index funds are so popular.

There are times, though, when an actively managed fund, while more expensive, can be a smart addition to your portfolio.

A good active manager will mitigate losses on the downside and typically participate in most of the upside, said Chip Wieczorek, a certified financial planner and investment advisor with Tradition Capital Management in Summit. On the other hand, he said, an index fund will rise and fall right in line with its relevant index.

He said he prefers a mix of indexes and active management.

If you choose an actively managed fund, you need to think about more than the expenses.

“Another major item to consider is which type of account you hold these funds in, as taxes are typically a large bite out of any portfolio,” he said. “Index funds are better served in a taxable account and actively managed funds are better served in a tax deferred account such as an IRA or Roth IRA.”

But, Wieczorek said, if you have a significant taxable portfolio, a managed individual stock account may be a better way to manage your downside risk and your tax liability.

“In most years, a portfolio of 50 stocks will provide a few big winners and a few losers,” he said. “You can let your winners run, thus avoiding — or postponing — paying capital gains tax until they are sold.”

He said tax loss harvesting by selling the losers builds a tax shield in the current year and for future years.

“Losses may be carried forward indefinitely to ward off capital gains taxes that may be as high as 15 or 20 percent, and can even provide a $3,000 deduction against other kinds of income,” he said.

If you make donations to charitable institutions, there’s another advantage. You can gift the appreciated stock to the charity, never pay the capital gains tax and still get the charitable tax deduction.

“Individual stocks are just a more tax efficient choice than funds or ETFs,” he said.

Another option is to leave the active management up to your non-correlated holdings such as private real estate, infrastructure, reinsurance or marketplace lending funds.

“These managers are providing true value by allowing access to assets that you could not acquire on your own which is a good compliment to an index portfolio,” Wieczorek said.

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This post was first published in August 2017.