What is an index fund?  What’s the difference between active and passive funds?

An index fund mirrors the stocks in an index.  The best known index is the S&P 500.  It is a group of 500 of the largest stocks.

So an index fund holds the stocks that are contained that index, usually weighted by market cap–the total market value of that stock.  Index funds can also hold bonds, other investments.

The beauty?  The fund company doesn’t determine what that list (index) is.  They just have to maintain a balance of the stocks in the fund.  They don’t have to do any research to choose which stocks are in the fund.  They don’t have to impress you with which stocks they have in the fund.  They don’t sell losers at year-end, at a low price, just because they don’t want you to see the losers in their prospectus.  They do have to keep it balanced.  If a stock goes up, they’ll need to sell some so it maintains it’s percentage in the fund.  But I would expect quite a lot of this is automated.

Index funds are often called passive funds.  An active fund is one where a manager or team study the stocks and decide which ones are good to buy and sell, and when.  A passive fund takes much less of this work.

What do you think is an advantage of an index fund?  Cost.  Index funds generally have much lower expense ratios (we’ll get to more about expense ratios in a future article).  That’s more money you earned rather than giving to the fund company.

But actively managed funds must perform much better than index funds right?  They have all those sharp financial folks working hard to find the best stocks.  It doesn’t work out that way as often as you’d think, particularly over longer periods like 10 or more years.  I’m sure in many cases, the folks running those funds are really sharp.  But predicting what a stock, or the market, is going to do in the future is really hard.  You can’t really do it consistently.  If someone could, they’d be really rich   Some will do well compared to the index for a streak, but it is hard to do that consistently.

Between index funds matching the market’s return, avoiding the variability of active fund returns, and having lower fees, they are hard to beat.

These days there are quite a lot of different indexes, and index funds.   You can invest in many different asset classes (such as “US Large Cap” or “Foreign Bonds” or “Emerging Markets”).  You can be quite diversified and you can easily balance between these classes using such funds.

The individual funds themselves offer quite a lot of diversification.  For example a “total US stock” fund contains all listed US stocks.  That mitigates some risk for you.  If one stock goes down, or even goes bankrupt, that doesn’t matter that much overall.  Actively managed funds tend to have less diversity, although they are still pretty diversified, certainly quite diversified compared to holding individual stocks.

Here’s a thought from Warren Buffet about low-cost index funds:

“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund (I suggest Vanguard’s). I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions, or individuals – who employ high-fee managers.”

– Rakesh Sharma, 3/24/2016.  Warren Buffett’s Love Letter to Index Funds.  Investopediahttp://www.investopedia.com/articles/investing/032416/warren-buffetts-love-letter-index-funds.asp

I’ll give a few more details about index funds, but it would be good if you do some research/reading to convince yourself.  I’ll put a few links at the end of the article.

It’s been said that index stock funds beat 70% of actively managed funds.  One article I came across says more like 80%.  It would depend on the time period measured, both which one and how long of a period.  How likely is it you’ll find one of those active funds that will beat the market going forward?  How likely that it will beat the market even after expenses?

A lot of the difference between active managers that beat the market, and those who don’t, is likely simply chance, probabilities.  If a manager or fund does really well for a few years, they look really good.  By what measures would you select an actively managed fund, with a high level of confidence you’ll beat the index?  If you don’t have a high confidence of that, might buying a fund following the index be a better bet?

The costs make a bigger difference than it would seem.

“The average cost of an actively managed fund is more than [1 percent], said Fran Kinniry, principal and head of portfolio construction at Vanguard. “What that means is that active management needs to outperform the market by at least that much to outperform at all.”

http://www.cnbc.com/2016/10/04/passive-investing-is-on-a-tear-and-for-very-good-reason.html

But no big deal, right?  It’s just 1%.  If your fund makes, say, 12% a year, who cares, right?

Let’s do the math.  For the first scenario, we’ll assume you get a 12% annual return (that’s dreaming, but we’ll discuss that later).  For our index fund, we’ll use a .04% expense ratio.  That’s realistic for a broad stock index fund.  And 1% for the actively managed fund.  We start with $10,000 and go for thirty years.  Note that this is a one time investment; no additional investments.

After 30 years, we have $296,405.80 in the index fund, $228,922.97.  The index fund is worth nearly 30% more.  12% is unrealistic, but I find with different growth rates, the difference in the resulting amount is pretty similar percentage wise.

I’m feeling like at this point I should mention this: you are not going to get a flat 12% annual return every year.  First because 12% would be an awfully good return.  On average, you might get 7-8% annually.  You may do a little better.  But more to the point, your returns are going to be variable.  You may get 30% one year, but you may get -30% another year.  You will lose money some years.  But over the years, on average, you should be able to get a decent return.

Part of the goal is to make you feel confident enough with the method you use so that you’ll stick with it in the bad years.  It is very, very easy to freak out when the market is down, give up and sell…right at the worst time…locking in your losses.

To summarize: why use index funds?:

  • Lower costs (but always check that for the individual fund)
  • Comes close to meeting the return of the index, which often outperforms comparable actively managed funds
  • Fantastic diversification
  • Easy to have a particular asset class
  • Simple rebalancing
  • Less research on your part

Some other resources relating to index funds:

Ilana Polyak, 10/4/2016.  Passive investing is on a tear, and for very good reason.  CNBC.  http://www.cnbc.com/2016/10/04/passive-investing-is-on-a-tear-and-for-very-good-reason.html

Ferri, Rick, 10/13/2011.  Buy, Hold, and Rebalance Works.  MorningStar. http://www.morningstar.com/cover/videocenter.aspx?id=397752

Christopher B. Philips, CFA; Francis M. Kinniry Jr., CFA; David J. Walker, CFA; Todd Schlanger, CFA; Joshua M. Hirt.  The Case for Passive Investing.  Vanguard.   https://personal.vanguard.com/pdf/s296.pdf

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