More Thoughts About Indexing

BY MATTHEW TUTTLE

While the article, “The Quest to Outperform” ( JofA, Jan.99, page 32) made some valid points about indexing, the author puts the cart before the horse.

The investment process does not begin by deciding what funds to invest in or whether or not to index. The process begins by identifying the client’s risk tolerance, time horizon, asset class preferences (if any) and expected or needed return to reach a stated goal. Only when this has been completed should a search be done for suitable investments that encompass a portfolio customized to the client’s needs. The main goal should be reaching the client’s stated objective, not outperforming or matching the performance of an index.

Imagine a period when the S&P 500 returns 9% a year while the client’s portfolio returns 10% a year. The client who needs 11% a year to retire may have beaten the index, but has not reached his or her goal.

The article also ignores risk-adjusted return. While many funds have recently underperformed the S&P 500, many also take less risk and are, therefore, more suitable for some less risk- tolerant clients. On the other hand, many funds take more risk and have the potential to significantly outperform the index, making them suitable for some more risk-tolerant clients.

While I’m sure the debate will continue to rage, I believe the investment process should be client driven and the adviser should approach a new client with an open mind. Only after an in-depth interview should a decision about investments be made.

Matthew Tuttle
Stamford, Connecticut

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