Index Fund Investment FAQ

I believe index funds should form the core of everybody’s investment portfolio.  There is a time and place for actively-managed mutual funds, to be sure, but I believe they should play a supporting role to the index-fund-dominated lead.  The following index fund investment FAQ is meant get you acquainted with this most attractive of investment vehicles.

Index Fund Investment FAQ

How Does Index Fund Performance Compare With The Competition?

In a word, very favorably.  The exact numbers depend on the exact time period you’re looking at, of course, but in general the average low-cost index fund will outperform 70-80% of the actively-managed funds in its category over 5-, 10, and 20-year periods.  Read Evaluating Mutual Fund Performance for more on the proper way to compare the performance of different mutual funds.

Are Index Funds Limited To Generating Just Average Returns?

In a word, no, which sounds counter-intuitive at first.  After all, the return of an index is, by definition, the average return off its individual components.  But in the real world, nobody can invest in an index.  Investing has costs, and the impact of costs on mutual fund returns can be staggering.  Index funds, by virtue of their simple investment strategy, have very, very low costs compared to other kinds of mutual funds.  Since real-world investment returns equal the average return of all the different individual components minus investment expenses like expense ratios, transaction costs (opens as a pdf), etc (as opposed to the theoretical cost-free index), the lowest-cost investment vehicle wins.  Index funds happen to be the lowest-cost investment vehicle, which explains why they consistently beat 70-80% of the competition.

In reality, index funds tend to generate above-average returns very reliably.

What Is The Main Advantage Of Index Funds?

As stated above, the main advantage of index funds is their low costs.  Simply tracking the performance of an index doesn’t require a cadre of highly-paid analysts, researchers, or a hot-shot, over-paid mutual fund manager.  An index fund can be run by an intern with a cheap coffee maker.

Other advantages of index funds include:

• No Style Drift – It’s quite common for mutual fund managers to go where the high returns are, meaning much of the time you really don’t know exactly what the fund is invested in.  This is especially true for so-called “go-anywhere” funds that are allowed to invest in pretty much anything they want.  With index funds, you know exactly what your fund is invested in at all times.
• Easier To Understand – There are no complex strategies to understand.  No rapid-fire trading.  Index funds buy the stocks in their index and hold them forever.  That’s it.
• No Manager Risk – What happens if your hot-shot manager decides to retire?  Just ask investors in Fidelity’s Magellan Fund (FMAGX), which was managed by stock-picking genius Peter Lynch.  The fund’s returns dropped like a rock after Lynch left (and wrote a great book about picking stocks).  By contrast, a drunken chimpanzee could run an index fund without any danger of its returns suffering.

What Is The Main Disadvantage Of Index Funds?

The main disadvantage of index funds is a psychological one.  Investing is more of a slow-and-steady-wins-the-race thing.  The tortoise almost always wins in the end.  Unfortunately, tortoises are also really boring.  Your index fund will never be the best-performing fund on the block.  You will never be able to brag about your index funds at parties and they won’t satisfy your gambler’s itch.  This is actually a major mental block you’ll have to get past before making an index fund investment.  You can console yourself with the fact you have a ton more money than the loudmouth blabbing about his recent mutual fund picks at a party.

What Criteria Should I Look For In A Good Index Fund?

There are only two things that matter when buying an index fund:  the index it tracks (that is, the asset class it invests in) and its expense ratio.  The index a particular index fund tracks will determine 99.999% of the return of any index fund.  The expense ratio will determine how well a particular index fund performs relative to other index funds tracking the same index.  All else being equal, the lowest-cost index fund will always be the top performer.  In this case, you get what you don’t pay for.

You can get information on expense ratios, indexes, and relative performance numbers from Morningstar.  I highly recommend signing up for a free account so you can take full advantage of all the Morningstar site has to offer.

Where Is The Best Place To Buy Index Funds?

The short answer is “anywhere you can conveniently buy a low-priced one.”  That said, there are two mutual fund companies that stand out from the rest when it comes to index funds.  The first, of course, is Vanguard.  Vanguard invented the index fund, and still carries by far the largest and best selection around, although Vanguard index funds aren’t necessarily the cheapest in all areas.  The other fund company coming highly recommended is Dimensional Fund Advisors.  DFA index funds tend to be more expensive than their Vanguard counterparts, but DFA offers index funds in several asset classes Vanguard neglects, such as small-cap value emerging market stocks.