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Why Advisers Are Recommending Index Funds

As the flat-fee system spread, advisers began selling no-load funds, and loads disappeared. In the 1980s, the big majority of adviser-sold funds came with loads of up to 8.5%. But by 2006, 53% of funds sold had no loads, according to Strategic Insight. By 2011, 80% of funds came without loads.

In the world of flat annual fees, the incentives of advisers have changed. Now an adviser gets paid more as a client's portfolio grows. In this environment, advisers have an incentive to prefer index funds because they often come with low annual expense ratios. To appreciate the appeal of low fees, consider an adviser who recommends an active fund with an expense ratio of 1.18%, the average figure in Morningstar's large blend category. Expenses are directly subtracted from returns. So the fat annual expense ratio shrinks the size of the portfolio and reduces the compensation of advisers. The adviser has an incentive to recommend a fund like Vanguard 500 Index (VFINX), which tracks the S&P 500 and has a low expense ratio of 0.17%.

Many advisers still prefer active funds because they aim to outdo the benchmarks. But active funds can be risky for an adviser. If an active manager trails the benchmark, then a client can become angry and fire the adviser. Index funds pose no such risk because they always track their benchmarks.

Will load funds disappear entirely? Probably not. Some advisers continue to sell load funds. The advisers say that there are cases when load funds are the cheapest choice. Say you hold a load fund for 20 years. You pay a 5% load up front, and then there are no more fees. That could be cheaper than paying a flat 1% annual fee for two decades. The advisers have a point. For some clients it makes sense to take actively managed load funds. By selecting top load funds, clients can obtain sound results.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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