Dec 13th, 2007
What’s an index fund (and why do I love them)?
An index fund (which is typically a mutual fund or its sister exchange traded fund) mirrors the market performance of an index of a specific financial market, such as the Dow Jones Industrial Average, the Standard & Poors 500, or any of a number of other such indices. As the index goes up, the fund goes up, and as the index goes down, the fund goes down. Given that historically the indices have gone up a lot more than down, an index fund is a convenient way to capture those gains. Index funds are passively managed, meaning they do not take the aggressive tactics of trying to time the market or buy and sell stocks to make gains, their fees are extremely low, and the taxes they generate are minimal–their returns ought to equal the performance of the index minus their fees. Many of the index funds out there–I am partial to those from Vanguard, although there are many, many more–also are available no load and can be purchased direct from the fund family at no cost.
The alternative, as far as funds go–and funds remain the best way for investors to get the safety net of diversification that is so desirable–are actively managed funds. There are several issues with these that make them much less favorable than index funds. Actively managed funds almost never beat the indices on a consistent basis and their costs and taxes are considerably higher than on passively managed index funds. In fact, their costs and taxes are so much higher that in order for them to be a better overall performer than an index fund, it must outperform the index by about 2%–and managed funds almost never match indices on a consistent basis anyway.
The real reason I love index funds, however, is this: it puts the power of the whole stock market into the hands of the small investor. It would be impractical if not impossible to buy one of every stock in the S&P 500, let alone the Wilshire 5000, yet in one fund, you can get all of those, and in one ETF, you can get one for likely under $100. That in and of itself is amazing; it’s the same reason I love things like personal computers, podcasts, and digital video–it brings power previously restricted to those with large amounts of money to the average consumer.
Do index funds have a place in your portfolio? I’d venture to say they ought to be in everyone’s portfolio, and in fact be the biggest portion of them!
