3 Things to Know About Index Funds

Index funds are investments that track a stock market index, such as the S&P 500. They’re popular with investors — index funds currently hold some $20 trillion of investor cash in them, and your workplace retirement plan is virtually guaranteed to offer one. Read on to learn three reasons why index funds are worth considering.

Index funds are passive investments recommended by Buffett and other experts

There are two main types of investment funds: mutual funds and ETFs, or exchange-traded funds. In general, mutual funds and ETFs come in two flavors: actively-managed funds and index funds. Actively-managed funds are helmed by managers who make trades and calibrate the fund’s portfolio in an attempt to outperform a particular market index.

The problem with that approach, according to Warren Buffett and a litany of other market observers, is that consistently beating the market is difficult, and very few professional investors can do it.

That’s where index funds come in. These mutual funds and ETFs aim to replicate the performance of a particular index rather than trying to beat it.

Over the long-term, investors in these funds have tended to come out ahead. Over the 10-year period ending in June 2021, just 25% of active funds achieved higher returns than passive funds tracking the same indexes, according to Morningstar.

Low fees can mean you earn higher returns

Part of index funds’ return advantage can be chalked up to what investors pay for them. Because there isn’t an active manager running the show and collecting a hefty salary, index funds tend to charge less in the way of management fees.

Over time, the fees you pay to own a fund, typically expressed as a percentage of the fund’s assets you owe on an annual basis and known as the expense ratio, can eat into your returns.

The average passive fund charges 0.12% in expenses, compared with 0.62% for the average active fund, according to the latest Morningstar data. Say you invest $10,000 into funds with those expenses and earned an average annual return of 8% over the next 40 years. At the end of the period, passive investors would have about $207,000, having paid about $9,500 in fees.

Fees for active investors would total more than $44,000, bringing their total to about $172,000, despite the fact that the fund earned the same return.

Index funds can provide cheap diversification

If you’re building a portfolio from scratch, index funds can provide a low-cost way to broadly diversify your investments. And building your portfolio with different kinds of investments can be important to you long-term returns.

Different types of investments perform differently under different market conditions. Take a look at investment firm Callan’s Periodic Table of Investment Returns to give yourself an idea of how often different horses take the lead in the proverbial race.

By investing in a broadly diversified portfolio, you give yourself a chance of having some money in what’s working while limiting the probability that your portfolio will take a plunge should one particular type of investment take a nosedive.

Index funds are one of the cheapest and easiest ways to access broad diversification. Investing in a total market index fund, for instance, gives you exposure to 97% of investable U.S. market cap, giving you access to companies of all sizes.

From there, experts say you can branch out by adding funds that cover broad swaths of the bond market or ones that invest in a wide array of international stocks.

“Those three types of funds, for a lot of investors, can form a perfectly suitable portfolio,” Ben Johnson, director of global ETF research for Morningstar, said. 

This content is informational purposes only and is not intended as investment advice.  The strategies and investments discussed may not be suitable for all investors.  Please consider your objectives, risk tolerance, time horizon and fees before making any investment.