The Value of Index Funds

What Are Index Funds

Index funds are portfolios of assets designed to match the movement of a particular financial market or index. The Vanguard 500 index fund for example, the first index fund invented by John Bogle in 1975, invests in the 500 stocks included in the S&P 500 Index. Because index funds are designed to match an index, returns will not beat the return of the index. However, index funds are highly likely to beat individual investors and managed funds, and their lower fees make them a better investment in the majority of cases. Regarding index funds beating managed mutual funds, Bogle wrote:

"I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."

Since the inception of Bogle's Vanguard 500, index funds have beaten managed funds by significantly more than 1.5%. The primary reasons for the better performance of index funds compared to managers who are able to do as well as the index (which is rare), are the lower fees and transaction costs of the index funds.

Tracking the Index vs. Picking and Choosing

Managed mutual funds involve a manager who picks and chooses stocks or assets based on speculation. Because no one can predict the future with a high degree of accuracy, much less consistency, index funds beat managed funds 90% of the time. Even if a fund manager is able to beat the index in any given year, over the long term the fact that index funds do far better will make them more profitable in the vast majority of cases.

Savings From Lower Fees

Because managed funds require a manager to pick and choose assets, there will be fees associated with this activity. Not only are there fees due to the fund manager, but also fees incurred when buying and selling throughout the year. While these fees may only amount to a couple of percentage points, 2% is a very big difference in investment gains. Even if a managed fun were to outperform the index by 2% (which is highly unlikely), the fees would eat up the gains.

Less Stress with Index Fund Investing

Index fund investing is simple. There's no need or benefit to looking at your investments on a daily basis, and no need to constantly move money from one place to another. Studies have shown that the more people think about money the less happy they are, and also that people focus more on losses than on gains. Index funds allow you to spend less time managing your money, lead to less stress from obsessing about your investments, and will very likely provide you with a greater return.

Why All the Press on Managed Funds?

Index funds are boring. They simply track the index with maximal diversity and minimal fees. There's not that much to write or say about them. Managed funds on the other hand always involve winners and losers, and in any given period there are better and worse managed funs that make great stories. Additionally, fund managers have more to gain by promoting their particular funds. So you're more likely to read or hear about managed funds, and see article on mutual funds you must have. Don't fall for it!

Additional Diversification

Just because index funds track a particular index doesn't mean you should invest in only one. Diversification is the key to success, and you're likely to do better with a diversified mix of index funds encompassing not only stocks, but also commodities and real state.