Index Funds Explained

Index funds refer to mutual funds or exchange traded funds (ETF) that tries to mimic the performance of a particular index. Some funds buy stocks and bonds using computer models that require minimum human intervention, while other more sophisticated ones will buy derivatives to help achieve its investment objective. The lack of active management usually means lower fees, which is one of the primary advantages of this type of fund.

The First and the Most Popular Index Fund

John Bogle, the founder of the Vanguard Group, is highly credited to creating the first index fund for the public.  It’s flagship index fund, the Vanguard 500 Index Fund (which tracks the S&P 500 index), started with assets of $11 million and now consists of assets under management in the range of $100 billion.

Bogle is a strong believer that while there will always be people who can outperform the market in the short term, overcoming the extra trading and management fees to consistently outperform the market is next to impossible.

Advantages of Index Funds

Index Funds have gathered a loyal following through the years with good reason.  In fact, I’m leaning more and more towards having an index only investment portfolio for all my investments.  Here are the reasons why it’s so great.

Index Funds Have Low Costs

Relatively lower anyway.  With active managed funds, you are probably looking at an expense ratio of at least 1% while index funds can be as low as 0.1%.  The small difference could add to significant savings over the long term.

Instant Diversification

Like any type of funds, investors can instantly gain diversification through an index fund because any index tracks a basket of stocks.  If we were to invest in individual securities like stocks, we better have lots of money or else diversification is difficult.

Simple and Closest Way of Passive Investing

Investing doesn’t really get simpler than buying index funds.  If you set it up so you automatically invest a periodic amount each month, it is totally automated.

Index Funds Offer a Better Indirect Tax Treatment

Compared to active managed funds, index funds buy and sell securities at a lower frequency.  This means less capital gains taxes at year end.  Paying taxes for the year when investments are way down are still possible, but it’s just not as likely and the amount is much more reduced even if it happens.

Much Easier to Asset Allocate Index Funds than Others

Mutual fund managers sometimes buy securities that do not match the fund’s prospectus (this is also known as style drifting).  For example, a large cap fund may start buying mid cap stocks for some reason.  This makes asset allocation extremely difficult.  Index funds also have a similar problem in that the companies’ stock may change so dramatically and quickly that it doesn’t fit the criteria of the index, but the frequency and chances are much less likely so the risk of it happening is drastically reduced.

What Index Funds Mean for Us

I’m contemplating whether I should slowly move all (or at least a majority of) my investments into some type of index fund because the simplicity and worry-free investing is really attractive for me.  Sure, it may not outperform the market in any given year but do I seriously think I can consistently outperform the market if the pros can’t even do it?

For most people who have lives away from the stock market, investing in index funds can be less worries, more time and higher returns.

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{ 6 comments… read them below or add one }

Adam Greaves March 18, 2009 at 10:16 am

Great article. I’m into real estate investing right now since I lost my shirt in the last year on the market but I’m interested in diversifying back to stocks. If I had my own trading account such as InvestorsEdge how would I buy an index fund?

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Investing School March 18, 2009 at 10:26 am

Adam: Assuming InvestorsEdge have access to ETFs, there are many that track indexes. For example, two popular ones are:

1. DIA which tracks tracks Dow Jones Industrial Average (which I own) and
2. SPY which tracks the S&P 500

ETFs work like stocks (for the most part) so you can buy and sell them during market hours.

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ObliviousInvestor March 18, 2009 at 1:47 pm

Excellent explanation of the benefits of index funds. (I’m a huge fan, as you know.)

Adam: Before investing in an ETF, be sure to check on its related expenses as well as what commission you’d have to pay.

The primary benefits of index funds are their low cost, and if you end up paying a commission (or a high expense ratio), it could easily negate that benefit.

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Ian Hickman March 19, 2009 at 5:04 am

Good article, certainly got me thinking about investing in index funds.

However, I’d be careful investing all of your money in them as your won’t be diversifying. Yes, there is a great diversification of stocks in the fund, but perhaps you should look to invest in something that has a negative correlation to the stock market too?

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Investing School March 19, 2009 at 8:09 am

Ian: Good point about diversification across asset classes as well as within a particular stock portfolio.

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index funds September 8, 2009 at 11:13 pm

Index funds seem to be quite a good investment option, though they don’t give you whooping returns. Over a period of time they grow steadily to give you good returns.

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