Lowdown on Index Funds

July 31, 2023

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 and growing popularity, not everyone knows precisely what index funds are – or how they compare to the many other funds offered by the marketplace. Here, we take a closer look and track how they perform over time compared to actively managed investments.

Key Takeways

  • Index investing has seen a massive rise in popularity over the past decade, with billions of dollars of investor money pouring into index mutual funds and ETFs.
  • Indexing is a passive investment strategy that seeks to replicate an index and match its performance, rather than trying to actively pick stocks and beat the index’s benchmark.
  • Index investing features lower fees, greater tax efficiency, and broad diversification.
  • Research shows that over the long-run, passive indexing strategies tend to outperform their active counterparts.

Active vs. Passive Management

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 fund managers test their skills by trying to pick stocks that will outperform the market. Since actively managed funds require more research and experience higher trading volumes, their costs are naturally higher.

On the other hand, managed funds Passive management is not trying to beat the market. Instead, a passive strategy seeks to match the risks and returns of the broader stock market or a segment of it. You can think of passive management as a buy and hold approach to money management.

What is an index fund?

An index fund is a passively managed activity: This is a mutual fund that attempts to mimic the performance of a particular index. For example, a fund that tracks the S&P 500 index would hold the same stocks as those in the S&P 500. It’s that simple! These funds believe that tracking market performance will provide better results than other funds.

What are the benefits of indexing?

There are two main reasons. make someone choose to invest in an index fund. The first is related to an investment theory known as the efficient market hypothesis. This theory holds that all markets are efficient and investors cannot earn above-normal returns because all relevant information that can affect the price of a stock has been included. its price. So index fund managers and their investors believe that if you can’t beat the market, you can too.

Second reason to choose an index fund. related to low cost ratio. Typically, the range for these funds is around 0.2-0.5%, much lower than the 1.3-2.5% typically found for actively managed funds. However, the cost savings don’t stop there. Index funds do not have a so-called sales fee, which many mutual funds have. however, when a bear market hits, higher expense ratios will become more apparent, as they are directly deducted from today’s meager profits. For example, if a mutual fund’s return is 10% and the expense ratio is 3%, the actual return for the investor is only 7%.

What’s missing?

One of the main arguments of active managers is that when investing in an index fund, investors give up before they even start. . These managers believe that the market has beaten investors to buy into these types of funds. Since an index fund will always achieve returns similar to the market it tracks, index investors will not be able to participate in any anomalies that may arise. For example, during the tech boom of the late 1990s, when shares of new tech companies hit record highs, index funds were unable to keep up with the record returns of some of the most popular funds. active management.

At the same time, actively managed funds that love stocks that are popular at the moment during an industry boom (or bubble) can reap great returns. They may also bitterly regret it if they go bankrupt (or break up). The advantage of an index is that it is more resilient than any individual stock. For example, an index fund that tracks the S&P 500 in 2008 would lose about 37% of its value. However, the index itself is up 350% since Jan 1, 2018.

What’s the result?

Generally, when looking at the performance of mutual funds over time. Long term, you can see a trend that managed funds underperform the S&P 500 index. A common statistic is that the S&P 500 outperforms 80% of mutual funds. While this statistic holds true for some years, it is not always the case.

Burton Malkiel, who popularized the efficient market theory in A Random Walk Down Wall Street, offers a comparison. better comparison. The 1999 edition of his book began by comparing a $10,000 investment in an S&P 500 index fund with a similar amount in the average actively managed mutual fund. From the beginning of 1969 to June 30, 1998, the index investor was leading by nearly $140,000: his initial $10,000 was multiplied by 31 to reach $311,000, while the active investor pole received only $171,950.

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