The Incredible Simplicity of Index Funds and Why It Matters

 Index funds

When it comes to investing, research shows that you’re better off embracing the boring. How is this done?

The primary way is to seek out low-cost index funds for your IRA, 401k, or other investment account, rather than using “actively managed” mutual funds. The research is consistent on this topic: Index funds outperform the vast majority of actively managed mutual funds over time.

What are index funds and how do they relate to actively managed mutual funds? The answer will help you become a better investor.

What is an Index Fund?

An index fund is a type of mutual fund that tracks a market index. You’ve heard of indexes before, but by a different name. The Dow Jones Industrial Average or the S&P 500 are two well-known indexes. These indexes track a certain type and collection of stocks. There are many types of indexes, each tracking different types of investment and asset classes.

The S&P 500 index, for example, tracks the 500 largest public U.S. companies--businesses like Apple, Exxon, GM, and Amazon. The index changes slightly when a company drops from the index and another, larger company moves in its place.

When you invest in an S&P 500 index fund, you are investing in a group of stocks that mirrors the S&P 500 index. This typically means your fund management fees are very low, because there isn’t much work for the fund management team to do over time. They just match the index.

Simple, kinda boring stuff, huh?

How Are Actively Managed Mutual Funds Different Than Index Funds?

Instead of investing in an index, actively managed mutual funds take an active role in trying to identify winning investments, rather than simply tracking an index. The management teams of these funds are usually trying to “beat the market,” meaning they’re trying to earn more than their comparable index.

They do this by researching different companies to answer one fundamental question: Which investments will outperform the comparable index? This is also called generating “alpha.” Fund managers look at a wide variety of factors to make these investment decisions. They’re smart people and well paid, and the appeal of beating the market is, well--exciting!

Since actively managed funds approach investing differently than an index fund, their fees are much higher. The assumption is that this is a fair exchange for investors--like you and me. The actively managed fund puts in more work to pick the winning stocks, and the investor receives a return that beats the index over time.

The Dog and Pony Show of Actively Managed Investing

Despite this perfectly rational belief that actively managed funds should outperform their index, it’s rarely reality.

As cited at the beginning of this article, author Larry Swedroe, a well recognized researcher and thought leader in the finance community, shows that historically, 80% of actively managed funds have failed to outperform their market index, especially when their higher fees are taken into account. He cites that today active managers are able to generate “alpha” only 2% of the time.

Historically, 80% of actively managed funds have failed to outperform their market index!

The promise of market-beating returns by an active fund manager is alluring, but it’s "smoke in mirrors" and doesn’t reflect the reality of most fund managers’ abilities.

What Would Warren Buffett Do?

Warren Buffett, one of the most successful investors of all time, has long been a sage of investment wisdom. At 87 years old, he’s still looked to for investment guidance and insight.

He’s often asked for investment advice. Here’s what he said in a recent shareholder letter:

"Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior...My regular recommendation has been a low-cost S&P 500 index fund.

"To their credit, my friends who possess only modest means have usually followed my suggestion. I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them,

"Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager…”

My regular recommendation has been a low-cost S&P 500 index fund.
— Warren Buffett

With all of his know-how and investment experience, Buffett simply recommends that investors should purchase low-cost index funds and avoid listening to the “siren song of a high-fee manager.” Will you heed Buffett’s counsel?

When Index Funds Aren’t Available

In many cases, such as with employer-sponsored retirement plans like a 401k, index funds may not be available to you. In this case, it’s always best to at least contribute enough to your plan to earn your full company match, if any. This free money “return” should never be ignored.

Once your full match has been received, it would be worth your time to look into other tax-advantaged options--like a Roth or Traditional IRA--where low-cost index fund investments will likely be more available to you.

 

I hope this discussion of index funds and their virtues has been helpful to you. Be willing to embrace the simplicity of index funds. The research clearly shows that investors would be better off investing in low-cost index funds and ignoring the long-term inferior returns of actively managed funds. If these investment options are available to you, you'd be wise to give them your consideration.