We must first understand what is an index. An index is something that measures the value and performance of a particular type of investment. For example, the Dow Jones Industrial Index is an index of 30 stocks that tends to be used to measure the performance of the U.S. stocks market (in particular large U.S. stocks).
Again, there are hundreds of indexes for all types of investments. These indexes are only mathematical calculations and not actual money. For example, the S&P 500 is an index of 500 U.S. stocks. The price of each of the 500 stocks is used to calculate the value and performance of the index.
An index FUND is simply a fund that is designed to replicate a given index with real money. For example, an S&P 500 index fund typically owns all 500 stocks in the S&P 500 index. Therefore, its performance is going to be virtually identical to the performance of the mathematically calculated S&P 500 index. These funds are considered to be passively managed meaning that they simply are designed to replicate the index and there is no manage actively trying to buy and sell securities.
Today there are 100’s of index funds…funds that are designed to replicate the performance of nearly every type of investment.
Not all indexes funds are created equally. As one example, there are many S&P 500 index funds and some will have very low fees and some will not.
An Exchange Traded Fund, or ETF, is a fund similar to a mutual fund. The primary difference is that an ETF is traded on an exchange like a stock while a mutual fund is only bought and sold at the close of trading once a day.
The majority of ETFs are also index funds (addressed in a separate FAQ). The advantage of ETFs over mutual funds is that ETFs are sometimes a little less expensive than a like-typed mutual fund and ETFs sometimes offer access to more types of investments.
There are generally two types of funds, passively managed (index funds) and actively managed. A passively managed index fund (addressed in a separate FAQ), such as an S&P 500 index fund, simply owns all 500 stocks in the S&P 500 and intends to replicate the performance of the S&P 500 index. An actively managed fund is own where there is a manager or team of managers whose job it is to try to buy and sell the right securities and the right time in an effort to perform better than an index.
The fact is that actively managed funds on average underperform like-type index funds. Higher costs, both higher expense ratios and other additional costs associated with operating the fund, are generally to blame for this poorer performance.
A custodian is the entity that holds your money or investments (your account). Brokerage firms and banks are typically the custodian of investors’ accounts. The custodian is responsible for the safekeeping and reporting on your account.
One way to dramatically reduce the risk of fraud is to separate the role of custodian and manager. This provides investors with a good checks and balances and makes it nearly impossible for a manager to fraudulently take your money.
Determining your risk tolerance is one of the very most important things you can do. Your risk tolerances is simply determining how much risk you are willing to take with your investments. Most often risk tolerance is determined by completing a questionnaire. These questionnaires are often very good tools.
Risk tolerance is both a combination of financial risk and emotional or psychological risk. Many investors can financial afford higher risk but emotionally they cannot handle the ups and downs that come with that higher risk.
Once an investor knows his risk tolerance, a portfolio then needs to be designed that is expected to deliver the desired level of risk.
An independent investment advisor, often a Registered Investment Advisor (RIA), is one who does not work for a brokerage firm. Independent advisors tend to be less motivated to sell products and instead focus on giving the best advice to their clients.
No. There is not a legal requirement that 401(k) plans have an investment advisory. Regardless, the vast majority of plans do have an investment advisor.
An investment advisor can often provide services that other plan service providers cannot. A 401(k) plan is an investment vehicle for its participants. There are typically 1,000’s of investment options to choose from to make available to participants in the plan. The plan needs an advisor with extensive experience to help select the appropriate 15-25 funds.
As an advisor to the plan, Patton provides a wide range of services including:
Other service providers, such as the recordkeeper and administrator, can provide advice to the plan but typically they have NO legal fiduciary responsibility to provide advice that is only in the best interest of the plan participants. Patton, often as the only service provider serving as a fiduciary to the plan, MUST provide only advice that’s in the best interest of its participants otherwise Patton could face legal consequences.
Patton’s goal is to help every participant accumulate as much money as possible for their retirement with as little effort and anxiety as possible. To help accomplish this goal, we do the following:
In addition to the above services, Patton is glad to assist participants in any way possible to help them meet their retirement goals.
Yes. We serve as a fiduciary to the plan requiring us to provide advice that is only in the best interest of the plan’s participants. We state this in writing in our agreement.
Note that most other service providers, such as recordkeepers and administrators, as well as most stock brokers, insurance companies and agents, and mutual fund companies do NOT serve as a fiduciary.
Transition from one recordkeeper to another can be very beneficial to the plan and its participants but it does require some effort on everybody’s behalf.
A transition typically takes about 60 days. Patton manages the entire process so that it is always clear what is need from whom and what needs to happen next. During this time, the point of contact for the plan sponsor (employer) will invest roughly 8 hours in the process. This will include a handful of conference calls, gathering information from the existing recordkeeper, scheduling participant education meetings, and communicating with participants.
Open architecture means that the plan recordkeeper allows nearly any investment fund to be selected and made available in the plan to its participants. This is important so that the best funds can be selected for the benefit of participants.
Some recordkeepers limit the list of funds that can be selected from. Often these are higher cost funds and/or proprietary funds that often do not serve the best interest of participants.
An independent advisor is one who is employed by a firm that is NOT a broker firm, insurance company, mutual fund company, recordkeeper, or similar firm. Employees of these other firms most often are very limited in what they can offer to a plan and its participants (they can only offer their company as the recordkeeper, they are compensated more to have their firms funds available in the plan, etc.).
An independent advisor can instead offer the services of any recordkeeper and recommend any investment funds for the plan with no limitations or alternative motives. This positions the independent advisor to provide the best advice possible to the plan and its participants.
Low costs. Index funds tend to be the lowest cost funds available. There is an index fund available for nearly every asset class (type of investment). Furthermore, extensive research has demonstrated that low costs funds simply produce higher returns that higher cost funds.
It is important to note that not all index funds are created equally. For example, some index funds are higher cost than other index funds that follow the exact same index. There are 1,000’s of index funds today to choose from and careful analysis must be done to select those that are best for a plan.