An Outline of Investing in Index Funds

Index funds are mutual funds which are invested in all companies on a particular index, such as Standard & Poor’s 500, rather than being actively managed by a fund manager who tries to invest only in stocks with the desired balance between risk and growth prospects. The advantage of index funds is that they normally have a lower expense ratio and do not rely upon the likelihood that a given management staff will be able to reliably pick winners. Instead, index funds are based on the belief that the overall trend of the stock market is always upwards as a whole and in the long term.

Traditionally, mutual funds were actively managed, meaning that a fund manager was employed to determine which stocks were most likely to yield high rewards (given the desired amount of risk) and regularly moved the funds’ money in and out of specific stocks and bonds accordingly. Most Americans still rely upon actively managed funds. However, passively managed funds, such as index funds, eliminate the role of the investment manager in favour of betting upon a very large number of stocks in a given area of the market, and hoping that, on average, these stocks will tend to rise rather than fall. Essentially, actively managed mutual funds place their trust in a few analysts to pick winning stocks, while index funds place their faith in the market as a whole to rise over the long term.

At least in theory, this seems to be a risky maneuver, since the stock market is prone not just to rapid growth but also to equally sudden contractions. However, supporters of index funds argue that investors reap significant savings by not having to compensate the management staff – expense ratios for index funds are typically less than 1 percent, but can vary considerably. In addition, and just as significantly, many fear that the skill and reliability of investment analysts has been greatly exaggerated. Actively managed mutual funds are premised on the idea that a highly skilled fund manager will be able to reliably “beat the market” when it comes to picking stocks and bonds to invest in. Some managers might be able to do that, but more will either fail, or simply appear to succeed by random luck. The average non-expert looking for a place to park their retirement savings probably won’t know how to tell the good from the mediocre.

For these reasons, academic studies have fairly consistently found that index funds are as good as or better than traditional mutual funds. Recently, for instance, Stanford University professor William Sharpe found that over the past 30 years the average life-time saver would be 38 percent wealthier if they invested in index funds which simply tried to follow the market up and down than by investing in mutual funds which actively tried to pick winning stocks. This is not just a flaw in American financial planning, either. In Canada, for instance, it was recently reported that only 41 percent of active fund managers were able to beat the index in a 12-month period, while just 10 percent were able to do so over five years.

Those interested in index funds face a much simpler choice than those investing in mutual funds, since there are comparatively few major indices for funds to track. Any major stock market index can be used as the basis for an index fund, or fund managers can develop innovative frameworks for building proprietary indices. In general, however, the most common index funds track widely publicized and well-known stock market indices like Standard & Poor’s 500 (for the United States), the Nikkei 225 for Japan, and the FTSE 100 for the United Kingdom. Banks, self-directed investment platforms, and financial planners often have a set of index funds as options for their consumers, although financial planners, in particular, may prefer to steer their clients towards actively managed funds.

Index funds are not perfect or guaranteed investments. Particularly over the short term, it is quite possible that the market will go down rather than up; this leads to potentially large losses. Index funds may diverge slightly from the index they are designed to track because of the way new cash is handled, a phenomenon known as “tracking error.” However, current research indicates that as long as the long-term trend of the market is upward, index funds can deliver superior results to traditional, actively managed funds.