1. Index Investing: Introduction
  2. Index Investing: What Is An Index?
  3. Index Investing: The Dow Jones Industrial Average
  4. Index Investing: The Standard & Poor's 500 Index
  5. Index Investing: The Nasdaq Composite Index
  6. Index Investing: The Wilshire 5000 Total Market Index
  7. Index Investing: The Russell 2000 Index
  8. Index Investing: Other Indexes
  9. Index Investing: Index Funds
  10. Index Investing: Conclusion

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. 


Index Investing: Conclusion
Related Articles
  1. Investing

    The Lowdown on Index Funds

    If you can't beat the market, why not join it? Read on to see what your options are.
  2. Investing

    The Hidden Differences Between Index Funds

    Not all funds match index returns. Find out how to avoid costly surprises.
  3. Investing

    3 Index Funds with the Lowest Expense Ratios

    Learn about index mutual funds with the lowest expense ratios.
  4. Investing

    The Hidden Flaws of Index Investing

    Index investing isn't always better than active investing. Here's why.
  5. Investing

    How Vanguard Index Funds Work

    Index funds allow investors to gain exposure to the market in a single, simple and easy-to-trade investment vehicle.
  6. Investing

    How to Use Index Funds to Diversify Your Portfolio

    Index funds can act as quality diversification tools.
  7. Investing

    4 Expensive Mutual Fund Mistakes to Avoid

    Mutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
  8. Investing

    The Top 5 Passive Equity Mutual Funds for 2016

    Examine five passive equity mutual funds that are poised to do well in 2016, as ranked according to their efficiency, performance and management skill.
  9. Financial Advisor

    The 3 Best Global Equity Index Mutual Funds

    These three no-load and low-fee global equity index mutual funds can add worldwide diversification and steady returns to a portfolio.
  10. Retirement

    Should Mutual Funds Still Be in Your Retirement Plan?

    Mutual funds are still widely used in retirement plans, but they may be losing their appeal. Find out if retirement mutual funds should be in your portfolio.
Trading Center