If you want to invest money in the stock market, there are various ways to go about it. You can buy shares in individual companies, but this involves doing lots of research and, ideally, having a solid grasp of how to read and analyze a set of accounts.
Investors who lack the time, knowledge, or inclination to invest in individual companies often use funds instead. This can be anything from using index funds or a traditional actively-managed fund. The latter involves you and lots of other investors handing over your money to a fund manager or team of fund managers, who invest your money in a wide range of companies.
The goal of the active manager is usually to “beat the market” – for their fund to deliver a better return than the wider market. For example, a fund manager investing in a basket of stocks might choose shares with the aim of beating the Standard & Poor's 500 index (S&P 500).
There’s just one problem: countless studies have shown that the majority of fund managers fail to beat the wider market consistently over the long run.
This is where index funds come in.
What is an index fund?
Index funds – also known as “passive” funds – don’t try to beat the market. Instead, they simply try to track its performance. So an S&P 500 index fund copies the composition of the S&P 500 index, with the goal of delivering the same annual return – at least, before costs are deducted.
Index funds may hold all (or a representative sample of) the stocks in the underlying index (“physical” replication), or replicate the performance of the index via buying derivatives (“synthetic” replication).
The first index fund that was available to ordinary investors was the First Index Investment Trust, which launched at the end of 1975 (it’s still going, but now it’s called the Vanguard 500 Index Fund). It was launched by Jack Bogle, the late founder of Vanguard, who is often described as the ”father of index investing”. At the time, critics of the fund warned that it would prove unpopular as “average” performance was unlikely to entice investors.
What are the pros and cons of index funds?
The big advantage of passive investing is cost: an S&P 500 index fund can have an annual charge of 0.1% a year, or even less. An actively managed fund could easily charge ten times as much, with no guarantee it will beat the index (most don’t over time).
But critics of index funds often point out that investors have no control over individual stocks when buying into them. There can also be significant upside when markets are doing well – but index fund investors can be exposed to downside risks when markets are faltering.
Given that actively-managed funds struggle to beat the market and are more expensive, it’s easy to see why index funds and passive investing have taken off in a big way in the last decade or so.
That said, certain types of active fund have a better record than others. And there are some smart people who argue that passive investing is at risk of distorting financial markets.
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