Taxes & Trading Costs
Actively-managed funds are also hindered by higher tax rates that come from active trading. Since managers usually make multiple trades per year, much of the profits they earn are subject to higher short-term capital gains taxes. Index funds only make trades when the benchmark they track changes, such as when a stock is dropped or added to the S&P 500. This results in only a few trades per year which are mainly subject to cheaper long term capital gains rates. Also, actively managed funds incur trading fees each time they buy or sell a stock, further eroding the gains.
Cash Reserves
Most active fund managers, in an attempt to time the market, will hold a portion of their total assets in cash reserves. These reserves earn miniscule rates of interest and can drag down the funds overall performance, especially during a bull market. Index funds hold nearly 100% of their assets in the securities of their benchmark, so they don't miss out on positive returns.
Style Drift
Style drift happens when a fund manager drifts away from the original strategy of the fund. For example, a manager of a fund that is supposed to invest in large-cap stocks may begin investing in small or mid-cap stocks. The manager may also invest in different asset classes, such as moving much of his or her portfolio from stocks into cash or bonds. Style drift is a particularly insidious problem for investors because it makes it difficult to compare a drifting fund with its supposed benchmark.
For example, in the 80s, the Fidelity Magellan fund was celebrated for consistently outperforming the S&P 500. The problem was that the S&P 500 was entirely American stocks, while the Magellan fund had up to 25% of its assets invested in foreign securities! Its performance was never measured against an appropriately weighted benchmark of domestic and foreign stocks, so its impossible to know if it actually beat the market. For more on this, check out the website of Index Funds Advisors, Inc. On the other hand, investors can be confident that an index fund's style will remain consistent. An S&P 500 index fund will include only the stocks of that index.
Conclusion
Every investor can benefit by making index funds a large portion or his or her portfolio. Index funds consistently outperform actively-managed funds, have substantially lower fees and tax costs, and stick unwaveringly to the style they advertise.
The quickest way for most people to invest in index funds is through their company-sponsored 401k or IRA plans. Most plans offer several basic index funds covering domestic and foreign stocks and bonds. If your plan doesn't have index funds, talk to your plan administrator about having them added, or consider setting up your own account. A good place to look is Sharebuilder, which has a PortfolioBuilder tool that can set you up with a diversified portfolio of index funds based on your unique circumstances. You can also check out Vanguard, which is considered the leader in the index fund industry and has a variety of index funds to suit any investor.
Much of the source material for this article came from the website of Index Funds Advisors, Inc., a portfolio management company that deals exclusively in index funds. There's a lot of great info there, so I urge you to check it out. Two excellent books that discuss the benefits of index funds are A Random Walk Down Wall Street by Burton G. Malkiel and Winning The Losers Game by Charles D. Ellis. They go into far more detail than this article and state the definitive case for investing in index funds.
Index funds are the best place to keep your long term savings and will provide superior returns over time. If you do a little homework and design a broadly-diversified portfolio of index funds, you will be nearly every professional money manager and be well on your way to a comfortable retirement. Good luck, and happy indexing.