An index fund aims to replicate the performance
of a target index, such as the
Standard & Poor’s
500 Index
or the
Russell 2000 Index
, by holding
the same securities that make up that index. While
not all index funds are exactly alike, choosing index funds to create a diversified portfolio is easier than differentiating among actively managed funds.
Index funds are also an appealing choice if you're seeking cost-efficient investments. The management fees and transaction costs are typically substantially lower than for an actively managed
mutual fund
. For example, the average equity fund has an expense ratio of about 1.5% plus
turnover costs
of about 0.9%, while many index funds are operated for less than 0.2% in annual expenses with negligible transaction costs, since the funds' investments change only when the index holdings change.
For instance, the following chart compares two hypothetical mutual funds — an index fund and an actively managed fund. While both funds earn a gross return of 8% annually, the index fund has annual expenses of 0.2%, while the actively managed has annual expenses of 2.4%.
Type of fund
Gross return
Expenses
Net return
Total gains:
1 year
Total gains:
10 years
Index fund
+8.0%
0.2%
+7.8%
$780
$11,200
Actively managed fund
+8.0%
2.4%
+5.6%
$560
$7,200
After one year, you would have about $220 more in the index fund than in the actively managed fund. And after ten years, you would have about $4,000 more in the index fund.
The downside?
When you invest in an index fund, you won't own the mutual fund with the best current record of performance. Based on the results of past decades, generally, two out of five equity mutual funds outperform the total stock market index over time. But, it's also typical for index funds to outperform at least 40% of equity funds in any given year.
The catch is that while a managed fund may provide marginally better returns with relatively the same amount of risk as an index fund, investing in an aggressive fund that may become a performance star for a period of time means incurring significantly greater risk. If you want to own a fund that ranks among the top 10% of all stock funds at the time you buy, you should also be prepared for it to rank among the bottom 10% at some point in the future. This risk doesn't mean you should avoid managed funds. You should simply understand — and feel comfortable with — the amount of risk you're taking.
Marc Lackritz
Marc Lackritz discusses the differences between index funds and actively managed funds.
There's an active and ongoing debate between people who advocate
index funds
as the best choice for most investors and those who advocate a balanced portfolio of actively managed funds. The first group points to the long-term merits of passive investing with index funds: broad
diversification,
weightings paralleling those of the stocks that comprise the market, minimal
portfolio turnover,
and low cost. Advocates of active management argue that successful mutual fund managers provide a real way to beat the market.
Marc Lackritz