Index funds [1] refer to mutual funds [2] or exchange traded funds [3] (ETF [3]) that tries to mimic the performance of a particular index. Some funds buy stocks and bonds [4] 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 [1] for the public. It’s flagship index fund, the Vanguard 500 Index Fund (which tracks the S&P 500 index), started with assets [5] 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 [6] through an index fund because any index tracks a basket of stocks. If we were to invest in individual securities [7] 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 [8] 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 [2] 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 [5] 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.