The Beginner’s Guide to Index Funds

Written by Jimmy Atkinson and Andy Hagans. Published November 17, 2015.

Get answers to basic questions about index funds in this second chapter of our Beginner’s Guide to Mutual Funds.

In this chapter:

What is an index fund?

An index fund is a special type of mutual fund, and many investors love them for their simplicity and low costs. Unlike an actively managed mutual fund — the goal of which is to outperform the market — an index mutual fund merely attempts to replicate an index, essentially allowing investors to buy the market. For instance, a typical S&P 500 index mutual fund holds the 500 or so stocks that make up the index. The fund manager of an index fund does not engage in active stock trading to attempt to beat the index. The fund just holds the components of the index, making only minor adjustments over time whenever the index dictates a change.

You can get a free PDF version of this report, The Beginner’s Guide to Mutual Funds: Download it here.

By replicating its underlying index, an index fund matches the performance of the index, less fees. For example, an index fund that charges an expense ratio of 0.10 percent will underperform the index by only 10 basis points per year. Because index funds are so efficient — they typically have very little turnover and there’s no complicated trading methodology for a fund manager to follow — fees are typically much lower than those for actively managed funds.

Indeed, index funds seek only to be average. But their efficiency and low-cost structure ensures that over the long run, index funds beat actively managed funds.

Why are index funds so popular?

For many years, all mutual funds were actively managed. Investors paid high fees to invest in funds that employed fund managers to actively buy and sell stocks on behalf of shareholders. The goal of these actively managed mutual funds was simple — to beat the market. Except, beating the market is not simple at all, especially if you take fees into consideration. As it turns out. it is hard enough for anyone (even a professional fund manager) to consistently beat the market. It is even harder to consistently beat the market by 1 percent or more (to cover fees) year after year, as illustrated in chapter four.

In 1972, Qualidex Fund was launched as the first index mutual fund. It sought to approximate the performance of the Dow Jones Industrial Average stock index. More than 40 years later, there is over $2 trillion in more than 900 share classes of equity index funds (as of year-end 2014, per ICI Fact Book). The number of index fund share classes and amount of money in index funds has shown tremendous growth over the last 20-plus years, as illustrated in the chart below. From 1993 through 2014, nearly $1 trillion has flowed into equity index funds.

Data source: ICI Fact Book

Brokers and other fund salesmen sure don’t like them, but for individual investors who want a simple portfolio, it’s hard to beat index funds.

Which is better, index funds or actively managed mutual funds?

In recent years, money has flowed out of actively managed funds and into index funds as investors have become increasingly concerned about what they pay in fees every year. From 2008 to 2013, stock index fund assets rose by 70 percent, compared to an 18 percent decline in actively managed stock fund assets. Clearly, index funds are gaining in popularity over actively managed funds, but does that make them better?

From a cost perspective, index funds beat actively managed funds hands down. In 2014, the asset-weighted average expense ratio for equity funds was 0.70 percent; for index equity funds, it was 0.11 percent.

From a tax perspective, index funds win again. Typically, index funds have much lower turnover than actively managed funds, resulting in greater tax efficiency.

So, when taking into account fund expenses and taxes, index funds have a huge advantage over actively managed funds. An actively managed fund that can consistently beat the market by 1 percent every year is likely only breaking even at best after fund fees and taxes. And consistently beating the market by 1 percent every year over the long term is very difficult to do.

Consider the chart below, which shows the percentage of large-cap core mutual funds that outperformed the S&P 500 index for every year from 1968 through 2006. In only two years out of 39 did the S&P 500 index’s performance finish in the bottom quartile against large-cap core mutual funds, versus 11 years in the top quartile. If beating the market were easy, most of the blue bars in the below chart would be below the 50-percent line (which would indicate that fewer than 50 percent of large-cap core mutual funds underperformed the S&P 500 index in a given year). But in fact, the S&P 500 index outperformed the majority of large-cap core mutual funds in 25 of the 39 years studied below, or nearly two-thirds of the time.

Data source: The Little Book of Common Sense Investing by John C. Bogle.

If you believe — like many investors still do — that actively managed mutual funds can beat the market, and yet they do so only one out of every three years, it’s time to rethink things. It should be clear by now that for broad equity investing, index funds have actively managed funds beat: they don’t cost as much in fees, they’re more tax efficient, and they generally perform better, too!

Where active funds may have an advantage is in relatively illiquid markets where pricing is more inefficient. This may occur in certain bond markets, which should compel bond investors to at least consider active funds. But in most cases, index funds are the best choice for investors.

What’s the difference between an index fund and an exchange traded fund (ETF)?

Because the vast majority of exchange traded funds (ETFs) track an index, they often get compared to index mutual funds. But not all ETFs are passively managed. In fact, as of September 2015, 8 percent of ETFs are actively managed. For the sake of simplicity, the remainder of this section will compare index ETFs to open-end index mutual funds.

You can get a free PDF version of this report, The Beginner’s Guide to Mutual Funds: Download it here.

The main difference is that index ETFs can be traded intraday on a exchange, just like stocks, whereas index mutual funds are purchased and redeemed with the fund issuer, and are priced only at the end of each trading day. The price of an ETF can fluctuate throughout the day and can trade at a discount or premium to the value of its underlying assets. The net asset value (NAV) of a mutual fund is set at the end of each day and accurately reflects exactly the value of all of the fund’s underlying assets — i.e., it trades at neither a discount nor premium.

There are several other subtle differences.

By now, you should have a pretty good grip on mutual funds and index funds. In chapter three, we’ll turn our attention to the logistics of purchasing funds.

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The Beginner’s Guide to Mutual Funds

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