They are designed to match a specific index. An index is a group of investments that measure how well companies are performing, like the Dow Jones Industrial Average or the S&P 500. When you invest in an index fund, you can generally expect the same returns as the market index.
For example, let’s take a look at the S&P 500. The annual performance of the S&P 500 over the long term averages about 10-11%, which is fantastic. It is difficult to beat those returns without taking on significant risks. That’s why index fund work so well.
If you do not know about index funds, you may be missing a great opportunity. Index mutual funds are an easy, inexpensive way for average investors to outperform most mutual funds on the market.
Index Funds vs. Actively Managed Funds
Index funds are different from most mutual funds. Most mutual funds have a professional money manager and try to gain an advantage by trading securities, but index mutual funds use a different technique called passive management.
Passive management is a completely different approach. Instead of trading actively, they only change their investments when the corresponding index changes. This translates to lower trading costs.
Actively managed funds generally have higher expenses than their index counterparts. Many index funds have an expense ratio of about .25%, while the average managed fund has an expense ratio of 1.5%!
Actively managed funds normally have sales charges and management fees, while index funds do not.
The mutual fund industry relies on the idea that professional managers will always find better investment opportunities than the average investor. The mutual fund industry wants you to believe this so they can earn a commission and fees on your investment.
If there’s one lesson to learn from the recent market downturn, it is that professional money managers don’t always do a great job.
Few mutual fund managers earn returns that make it worth paying their management fees. There are some mutual fund managers who can consistently find great investments and keep management fees low, but they are difficult to find. That’s one reason why I post the best mutual funds here on the website.
Actively managed funds are fine if they are thrifty and produce great long-term returns, but most of them do not. Index mutual funds are popular because they have fewer obstacles than most mutual funds and provide a few key advantages to average investors.
Benefits of Index Funds
It doesn’t take a rocket scientist to figure out that average returns minus investment fees will give you below average returns. Even a fifth-grader can do that kind of math.
Beating most other mutual funds is a huge plus, but index funds have some other great advantages. Here are a few of them:
- You pay much lower management fees on your investment, due to less frequent trading.They also have lower volatility than the average mutual fund, which can help minimize losses if the market doesn’t perform well.
- The low turnover rate will also keep your fund’s trading expenses down. This can help you avoid any bad judgment calls by a professional manager.
- They keep very little cash and invest almost all of the fund’s capital into an index. Staying fully invested will maximize your returns when the market is performing well.
- Low investment minimums will make it easy for you to get started. If you have a few thousand dollars, you can usually invest in an index fund. That minimum may be much less if you are investing automatically.
It is hard to go wrong with index investing. Since most mutual funds don’t outperform the market average, you can outperform most everyday investors simply by investing in an index fund.
How To Evaluate Index Funds
Evaluating performance for index funds is very simple. You want to consider two things: how much they will cost you, and how closely they match the index.
You should not pay investment fees or sales charges to invest. This will save you money from day one. If you don’t pay a sales charge, you will already be ahead of all the other investors that pay them (trust me, a lot of investors do).
Make sure the annual costs are low for your fund by choosing one with a very low expense ratio (lower than .5%).
Some funds also do a better job of matching indexes more closely. The best way to measure this is a fund’s beta. You want a measurement of exactly 1. If the beta is too much higher or lower than 1, you may get unexpected returns.
Index funds also carry the same risks as any other mutual fund. Funds that match a stock index will have the same risks as most stock funds. Funds that match a bond index will have the same risks as most bond funds. You don’t need to take any unnecessary risks to invest in an index mutual fund and earn the same returns as the market average.
You will also need to decide which index to match. The S&P 500, Dow Jones Industrial Average, and NASDAQ are the three major stock indexes, but there are many other indexes to invest in.
Are Index Funds Right For You?
Index funds are very simple and cost-efficient, which can lower your investment costs and give you an easy advantage over most mutual fund investors (especially the ones paying a sales charge).
Conservative investors usually invest in index funds because of their low costs and easy-to-track performance. You can’t turn on the new these days without hearing what the stock market closed at. The major market indexes have also been around around for a long time, so investors are more familiar with them.
Index investing will provide a good foundation for your portfolio and give you a benchmark to measure the rest of your investments against. After all, they do try to match the performance of market measurements.
To start out successfully as an investor, you should avoid sales charges, keep your fees low, and invest in funds with low volatility. Index funds do all of these things while outperforming most mutual funds on the market.