Index Investing: Index Funds

Market indexes are great tools for telling us what direction the market is taking and what trends are prevailing. So, how do we buy into these investment vehicles? Imagine the costs associated with buying the 500 stocks that make up the S&P 500. Commissions alone would run into the thousands, not to mention the hassle of sorting out the taxes.

Instead of buying individual stocks, you can invest in something called an index fund – a type of mutual fund that’s based on an index and that mirrors its performance. There’s an index, and an index fund, for nearly every market and investment strategy out there.

The idea behind index funds has some academic substance to it. For years, many academics argued that it’s impossible to consistently beat the market without raising your risk level – a theory known as Efficient Market Hypothesis (EMH). So in 1975, John Bogle, founder of The Vanguard Group, took the stance that "if you can't beat 'em, join 'em," and created the first low-cost mutual fund that mirrored the S&P 500 Index. 

In reality, the majority of mutual funds fail to outperform the S&P 500. The exact stats vary depending on the year, but on average, anywhere from 50%-80% are beaten by the market. As of June 30, 2017, 82.38% of U.S. funds underperformed the S&P 500 during the previous five-year period (that means only 17.62% of funds did better than the Index). That’s according to SPIVA Scorecard data from S&P Dow Jones Indices.

The main reason for this is the costs that mutual funds charge. A fund's return is the total return of the portfolio minus the fees you pay for management and fund expenses. If a fund charges 2%, you have to outperform the market by that amount just to break even. 

Here's where index funds enter the picture. Their main advantage is lower management fees than you would get from a regular mutual fund. Index funds are about a third of the cost of typical active mutual funds. While expenses have declined substantially since 2000, non-index funds now have an average expense ratio of 0.63% (for 2016), while many index funds end up around 0.05%. That small change in fees can make a huge difference when it comes to your returns – especially over the long-term.

The reason the costs are lower is because index funds are not actively managed. Fund managers only need to maintain the appropriate weightings to match the index performance – a technique known as passive management. The deceptive thing about the "passive" label is that most indexes are actively selected. Take the S&P 500, for example: When the index changes, it's almost like getting the S&P Index Committee's advice for free. 

Unlike mutual funds, which try to beat their benchmarks, most index funds aim to match their index.

Of course, investing in an index fund doesn't guarantee you'll never lose money. You’ll likely follow the market down in a bear market and up in a bull market. Historically, the annual return of the S&P 500 has averaged about 10%. The key here is to hold on for the long term. It’s not the day-to-day returns that matter; it’s the returns over time that count.