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By Christine Benz and Michael Rawson, CFA | 04-17-2015 03:00 PM

4 Passive-Investing Pitfalls to Avoid

Don't assume all index funds are low cost and tax-efficient, and avoid overdiversification and becoming too hands-on, says Morningstar's Mike Rawson.

Note: This video is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. A portfolio of index funds or exchange-traded funds might be easier to set up and maintain than a portfolio of actively managed funds, but it's not foolproof. Joining me to share four common mistakes that investors might make with index products is Michael Rawson; he's an analyst with Morningstar.

Mike, thank you so much for being here.

Mike Rawson: Thanks for having me, Christine.

Benz: So, certainly, there are a lot of advantages to an all-index portfolio: It's certainly easier to oversee the moving parts, and it's easier to rebalance and do portfolio maintenance. But people can make mistakes with index product. So, you've compiled some of the common ones that investors make. And let's start with the first one: It's that investors have heard so much about index funds' and exchange-traded funds' low-cost advantage; they might tend to believe that all index-based products are low cost, but that's not true.

Rawson: No. It's not true. In fact, there are a lot of high-cost index funds. Index-fund providers--fund companies that are jumping on the bandwagon, seeing all the flows to index funds--might say, "Well, if we put the word 'index' on this fund, it's going to attract flows because people just associate indexing with maybe a fair return and low cost; but it's not always the case that index funds are low cost.

For example, there are about 53 S&P 500 funds out there, but the best ones charge 10 basis points or less; now that compares with an average actively managed fund or large-blend fund with an expense ratio of about 1.1%. So, those low-cost S&P 500 funds have about a one-percentage-point expense-ratio advantage, which makes it difficult for the average active manager to overcome that hurdle every year. But there are a handful of S&P 500 funds that charge more than 1%, and I personally wouldn't want to pay a high expense ratio for what could be a very low-cost vehicle. So, making the assumption that I'm automatically going to get a low-cost fund if I go with an index is something that people need to be wary of.

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