Why You Should Invest In Index Funds
"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals." -Warren Buffet
If you've read some of the other articles here on Be Cheap Be Rich, you know that we advocate cutting your daily expenses and investing those savings for the future. You may have also noticed that we reccommend investing in index funds, but you may be wondering what exactly they are. This article will explain index funds and show you why, over time, they are the smartest place to invest your long-term savings.
Index vs. Actively Managed Funds
In the mutual fund world, there are two basic types of funds--actively managed and passively managed. Actively managed funds are the kind most people are familiar with--they are run by a manager who buys and sells stocks and bonds throughout the year in order to beat a specific benchmark, such as the S&P 500 or Russell 2000. On the other hand there are passively-managed, or index, funds are funds that are designed to mimic the performance of a specific index. A common kind of index fund is one that tracks the S&P 500. Basically if the S&P 500 goes up 10%, the index fund will go up by about the same amount. There are literally dozens of different types of index funds that track sectors such as the NASDAQ, Wilshire Total Market Index, and foreign stocks, to name a few.
What are the reasons to choose index funds over actively-manged ones? Here are the most important reasons:
Superior Performance
The most important reason is also the simplest. Over time, the vast majority of actively managed funds do not beat their benchmark indexes. In fact, studies done by Standard and Poor show that on average index funds beat 80% of actively managed funds. You can find more here. An excellent study was done by Thomas P. McGuigan in the Journal of Financial Planning, which compared the Vanguard 500 Index Fund with a representative group of 171 large-cap, actively managed funds. McGuigan found that over the twenty years from 1983 - 2003, the Vanguard fund outperformed 90% of the active funds. Similar results were found for mid-cap and small-cap funds as well.
Will some funds consistently beat the market? Yes, they will, but you have at best a 20% chance of picking the right fund.
Fees
Active funds fare so poorly for several reasons. First, because they have to pay for managers and research teams, they charge substantially higher fees than index funds. A typical index fund may charge a 0.2% expense ratio, meaning if the fund earns 10% one year, you will have earned 9.8% after expenses. Active funds can charge fees of 0.5% - 2%, which may not seem like much, but can add up over time. For example, compare the Vanguard 500 Index Fund (symbol VFINX) with the actively managed Fidelity Large Cap Stock Fund (FLCSX). Expense ratios are .18% and .78% respectively. Seemingly not a big difference, but over twenty years, assuming similar performance, you'll earn an additional eight thousand dollars with the Vanguard fund on an initial $10,000 investment. You can use this calculator to see the dramatic difference fees can make over time.