Member preview

What is an Index Fund?

And Why I Won’t Stop Talking About Them

What is an Index Fund?

Index funds are investment funds designed to match the performance of a market index. As an example, the most popular form of Index funds is designed to match the performance of the Standard and Poor’s 500 Index AKA the S&P 500. Index funds are similar to mutual funds in that they both have a fund manager who acquires the underlying assets that determine the value of the fund.

However, there are two key differences between index funds and traditional mutual funds that (in my opinion) elevate index funds above traditional mutual funds.

1. Index Funds are passively managed and;

2. Index Funds have lower expenses

Passive VS Active Management

“Fidelity did a study a few years back and determined that the account holders whose investments had the best performance had one thing in common: they were dead.”

Traditional mutual funds are actively managed, meaning the fund manager is picking individual stocks and investments whereas index funds are passively managed, meaning the fund manager is only buying stocks to match the composition of the index they are tracking.

Using the example of the S&P 500, an index fund manager will only buy stocks to mirror the stocks and the weight of those stocks within the S&P 500. For example, if technology stocks such as Amazon and Facebook account for 25% of the S&P 500 Index, an index fund tracking the S&P500 will aim to have those same technology stocks account for 25% of the index funds value.

An active manager of a traditional mutual fund will try and pick which stocks he or she thinks will outperform the market. The problem with active management (apart from the additional fees that come with it) is that the majority of stock pickers cannot outperform the market over the long term. I could drone on and on about “the efficient market theory” and all of the studies and data that show how few active managers can outperform the general market in the long term, but there is one study that sums things up nicely.

Fidelity did a study a few years back and determined that the account holders whose investments had the best performance had one thing in common: they were dead. There is no manager who is more passive than a dead person. The reason for this is that even the most brilliant investors do not have a crystal ball, no one knows what the future holds, as humans we tend to make overly emotional decisions which cloud our judgment, especially when it comes to money. Passive investing takes the emotion and human error out of investing.

The other thing that is great about the passive approach to index fund investing? They are cheaper than actively managed mutual funds

Management Expenses and Impacts on Long-term Returns

If you are investing in the stock market there is really only one variable you can control, your cost. How much are you paying to acquire the stocks you are investing in? Both mutual funds and index funds have what are called management expense ratios (MER). The MER is a ratio for what you are paying in management fees as a percentage of the total assets you own in the fund.

It is common to find equity mutual funds have an MER of around 82 basis points or 0.82%. Meaning if you have $10,000 invested in that mutual fund it will cost you $82 per year to pay for the services of the manager and other costs associated with the fund.

Compare that to the Vanguard S&P 500 index fund, which at the time of writing this has an MER of 4 basis points or 0.04%. Meaning if you have $10,000 invested in this fund, it will cost you $4 per year, a fraction of the cost of a traditional mutual fund.

The impact of Expenses on long term returns

The table above outlines the impacts that MER has on your investment returns over the long term. If you were to invest $10,000 today into an index fund with an MER of 0.1% that grows by 9% per year, after 40 years you would expect that $10,000 to grow to $302,772.

Given the passive nature and low cost of index funds, it is currently where I am currently putting the bulk of my investments. But don’t take it from me, I’ll leave you with a quote from legendary investor Warren Buffet from the 2014 shareholders meeting of Berkshire Hathaway on the subject of index funds.

“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: 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.”

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.