Many in the investment world spend a lifetime trying to predict short-term movements in markets, business cycles, and sectors. There’s plenty of incentive. If you bet right, more often than not, you increase your wealth. Trouble is, nobody can consistently bet right, because nobody can reliably predict market outcomes. For the farsighted investor, this fact casts doubt on the ultimate effectiveness of active investing. More importantly, it shines a big bright light on the well-documented, long-term value of index fund investing.
Let’s get up to speed. The Vanguard Group introduced the first index fund, the VFINX, in 1976 to offer investors a low-cost, diversified investment. Unlike traditional actively managed funds, index funds are not intended to outperform the market. Rather, they are set up to passively track the performance of a particular market index at a much lower cost than actively managed funds where portfolio managers and traders make decisions on which stock to buy or sell.
Initially, managers of active funds and other mainstays of the established investment management industry criticized Vanguard’s move. But over time, index fund investing gained traction and ultimately reshaped the industry. Today, these once obscure funds comprise more than 22 percent of equity mutual fund assets, according to the Investment Company Institute. That’s double their share a decade ago.
There are two main ways to invest in index funds: index mutual funds and “exchange-traded funds” (ETFs). Both types of index funds are designed to track a specific market index, meaning they are comprised of the same exact stocks, bonds, or both, and in the same weightings. So, if the S&P 500 Index gained 4 percent, the State Street SPDR S&P 500 ETF (SPY) that tracks it should also, less tracking error and fees.
Other major market indices include the Dow Jones Industrial Average, the Nasdaq Composite Index, and the Russell 1000 Index, which many consider some of the definitive benchmarks for the U.S. stock market. But there are many more indices. In fact, there are indices for nearly every conceivable subsection or cross-section of the global economy. Likewise, there are many categories of index funds, such as for U.S. stocks, foreign stocks (e.g., emerging market index funds), real estate, bonds, and myriad niche and special-interest categories such as robotics funds, green energy funds, and socially conscious investing funds.
These funds give ordinary investors a wide array of lower-cost investment options. And over the long run, index funds tend to outperform comparable managed funds. Why? Actively managed mutual funds often have higher expenses, including management and marketing fees, in addition to other costs associated with active stock picking. This makes their cost structures higher.
Indeed, the average total annual expense ratio for actively managed U.S. equity funds was 0.84 percent of assets in 2015, according to the Investment Company Institute. That compares to 0.11 percent for index funds. While seemingly small, the difference can have a huge impact. For a fund averaging an 8 percent return, the 0.83 percent expense ratio would eat about 10 percent of your return while the 0.11 percent ratio would only sap 1.25 percent. These passively managed index funds have drastically lowered the investment management fees that sap investors’ earnings over the long term.
This is especially good news for young investors who have relatively small holdings but all of the advantages of the time value of money on their side.
John C. Bogle, the founder of the Vanguard Group, is notoriously skeptical of actively managed funds. He has argued publicly that fund managers put up none of the invested capital and assume none of the risk, yet they still take a substantial cut of investors’ money.
Bogle and others point out that the growth of index fund investing is a clear indicator of the long-term benefits of investing in the stock market. That is, if your strategy is focused not on actively picking winners, but on the long-term expansion of U.S. and global business.
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Commentary is provided for educational and information purposes only and should not be considered as investment advice. Investing involves risk including the risk of loss. Before investing, consider your investment objectives, financial resources and risk factors.
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