The Lowdown On Index Funds

By Investopedia Staff AAA

Index funds have provided investors with a return that is directly linked to individual markets while charging minimal amounts for expenses. Despite their benefits, not everyone seems to know exactly what index funds are and how they compare to the many other funds offered by different companies.

Active and Passive Management
Before we get into the details of index funds, it's important to understand the two different styles of mutual-fund management: passive and active.

Most mutual funds fit under the active management category. Active management involves the art of stock picking and market timing. This means the fund manager will put his/her skills to the test trying to pick securities that will perform better than the market. Because actively managed funds require more hands-on research and because they experience a higher volume of trading, their expenses are 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 stock market or a segment of it. You can think of passive management as the buy-and-hold approach to money management.

What Is an Index Fund?
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 that tracks the S&P 500 index would own the same stocks as those within the S&P 500. It's as simple as that! These funds believe that tracking the market's performance will produce a better result 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 and more. (For more on this subject, see this Index Tutorial.)

What Benefits Are They Providing?
There are two main reasons why somebody chooses to invest in an index fund. The first reason 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 above normal returns because all relevant information that may affect a stock's price is already incorporated within its price. Thus, 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 is 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. But the cost savings don't stop there. Index funds don't have the sales charges known as loads, which many mutual funds have.

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

What Are You Missing Out On?
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 if any anomalies occur. For instance, during the tech boom of the late '90s, when new technologies companies reached record highs, index funds were unable to match the record amounts of some actively-managed funds.

What Are the Results?
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 his book "A Random Walk Down Wall Street". The 1999 edition of his book begins by comparing $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 to 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.

Are Index Funds Better?
It's true that over the short term some mutual funds will outperform the market by significant amounts. But picking the good funds out of the thousands (literally) that exist is almost as difficult as picking stocks yourself! Whether or not you believe in efficient markets, the costs in most mutual funds make it very difficult to outperform an index fund over the long term.

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