All About Index Funds

For decades, the stock market was the exclusive stomping ground of the nation’s business elite.  Transaction costs at a full-service brokerage were enough to bankroll a family of five for a month, or so it seemed.

What Is An Index Fund?

An index fund is simply a mutual fund that tracks an unmanaged basket of stocks called an index.  Two of the most popular indices are the S&P 500 index, which contains 500 of the largest stocks in the United States, and the Dow Jones Industrial index, which contains 30 industrial stocks recognized as leaders in their industry.  It doesn’t stop there, however:  there is an index for practically every market segment you could think of, from small-cap international stocks to gold stocks to specific countries such as Chile or India.  Since index funds merely track an already-existing index, management and transaction costs are minimal.  It’s not uncommon for an index fund to have expenses totaling less than 1/5 of its average peer.

History Of Index Funds

Even worse, financial information on publicly listed companies was spotty and difficult to obtain, at best.  Investors like Benjamin Graham made a fortune by sifting
through archaic and unreliable financial statements of boring industrial-era companies; however, anybody who did not possess  the specialized training required (or the means to purchase such services from a professional) was out of luck.  Thus, participation in our nation’s economic prosperity was limited to the fortunate few.  Fortunately that began to change following WWII.  Investment companies, or mutual funds, sprung up all over and steadily gained in popularity not just among the investing elite but also among the growing middle class.  Like never before, a nation’s rich and poor a lot shared in the good times.

Everybody was happy, for a while.  But mutual funds of the 50’s and 60’s were expensive and secretive.  Asset management fees were outrageous by today’s standards and severed only to enrich money managers at the expense of the ordinary investor.  To add insult to injury, it turns out these exorbitant fees didn’t even result in superior returns.  To the contrary, the vast majority of professional managers under-perform a broad unmanaged index of stocks on a consistent basis.  Then, in 1976, the Vanguard Group founded by John Bogle released the Vanguard 500 Index fund.  An oddity in its day, the Vanguard 500 fund tracked a basket of 500 of the largest stocks trading on the New York Stock Exchange.  Since it merely tracked a well-defined index, no market research was necessary:  no visiting companies, no expensive financial analysts.  Hence, the Vanguard 500 had an expense ratio only a fraction of the average actively managed fund.

Why Choose Index Funds?

Morningstar, a respected provider of mutual fund statistics and research, found that fund expenses are the only reliable indicator of future performance.  That is, cheaper funds tend to perform better over the long term than expensive funds and it’s easy to see why when you think about it.  Theoretically, the TOTAL return of all mutual funds, pension funds, insurance funds, and all other market players must equal the return of the unmanaged index of all US stocks minus transaction and management costs.  Empirically, you can observe the average return of all mutual funds tends to trail the relevant index by the average asset-weighted expense ratio of those funds.  Since index funds have a large expense advantage over any actively managed mutual fund, they must by definition have above-average returns in any significant time period.  Thus, if you want above-average returns, just buy an index fund.  Index funds are miracles of modern finance and, in my opinion, should form the core of every investor’s portfolio.