The Lowdown on Index Funds

Index funds provide investors with a return that is directly linked to individual markets, while charging minimal amounts for expenses. Despite their benefits, far from everyone knows precisely what index funds are – or how they compare to the many other funds offered by the marketplace.

Before we get into the details of index funds, it's important to grasp the two prevailing styles of mutual-fund management: passive and active.

Most mutual funds fit in the active-management category. Active management involves the twin arts of stock picking and market timing. This means that the fund manager puts his or her skills to the test in trying to pick securities that will outperform the market. Since actively managed funds require more hands-on research, and because they experience higher trading volumes, their expenses are naturally higher.

Passively managed funds, on the other hand, do not attempt to beat the market. A passive strategy instead seeks to match the risk and return of the broad stock market or a segment of it. You can think of passive management as the buy-and-hold approach to money management.

An index fund is passive management in action: It is a mutual fund that attempts to mimic the performance of a particular index. For instance, a fund tracking the S&P 500 index would own the same stocks as those in the S&P 500. It's as simple as that! These funds believe that tracking the market's performance will produce a better result as compared to the other funds.

Remember, when people talk about "the market," they are most often referring to either the Dow Jones Industrial Average or the S&P 500. There are, however, numerous other indexes that track the market, such as the Nasdaq Composite, Wilshire Total Market Index, Russell 2000, et al. (For more on this subject, see our Index Tutorial.)

There are two main reasons why somebody chooses to invest in an index fund. The first is related to an investing theory known as the efficient market hypothesis. This theory states that all markets are efficient, and that it is impossible for investors to gain larger-than-normal returns because all relevant information that may affect a stock's price is already incorporated into its price. And so, index fund managers and their investors believe that if you can't beat the market, you might as well join it.

The second reason to choose an index fund has to do with the low expense ratios. Typically, the range for these funds is around 0.2-0.5%, which is much lower than the 1.3-2.5% often seen for actively managed funds. Yet the cost savings don't stop there. Index funds don't have the sales charges known as loads, which many mutual funds do.

In bull markets, when returns are high, investors may not pay these ratios much heed; however, when bear markets come around, the higher expense ratios become more conspicuous, as they are directly deducted from the now meager returns. For example, if the return on a mutual fund is 10% and the expense ratio is 3%, the real return for the investor is only 7%. 

One of the major arguments of active managers is that by investing in an index fund, investors are giving up before they have even started. These managers believe that the market has already defeated investors who are buying into these types of funds. As an index fund will always earn a return identical to that of the market it is tracking, index investors will not be able to participate in any anomalies that may occur. For instance, during the tech boom of the late '90s, when the stocks of new technology companies reached record highs, index funds were unable to match the record returns of some actively-managed funds.

At the same time, actively managed funds that become enamored of the darling stocks of the moment during a sector boom (or bubble) may profit handsomely. They may also regret it bitterly in the event of a bust (or burst). The advantage of an index is that it's much more likely to recover than any individual stock. For example, an index fund tracking the S&P 500 in 2008 would have lost approximately 37% of its value. However, that same index rose by 350% by January 1, 2018. 

Generally, when you look at mutual fund performance over the long run, you can see a trend of actively-managed funds underperforming the S&P 500 index. A common statistic is that the S&P 500 outperforms 80% of mutual funds. While this statistic is true in some years, it's not always the case.

A better comparison is provided by Burton Malkiel, the man who popularized efficient market theory in A Random Walk Down Wall Street. The 1999 edition of his book begins by comparing a $10,000 investment in the S&P 500 index fund to the same amount in the average actively-managed mutual fund. From the start of 1969 through June 30, 1998, the index investor was ahead by almost $140,000: her original $10,000 increased 31-times to $311,000, while the active-fund investor ended up with only $171,950.

It's true that over the short term, some mutual funds will outperform the market by significant margins. Picking those high performers from the literally thousands out there is almost as difficult as picking stocks yourself! Whether or not you believe in efficient markets, the costs that come with investing in most mutual funds make it very difficult to outperform an index fund over the long term.