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On Finance: Understanding the Advantages of Index Funds


Illustration by Jorgen Burt

Index funds are all the rage. These low-cost, market-tracking investments have captured the attention of all investors, including beginners and seasoned veterans. Morningstar, Inc. reported that in 2016, industry titan Vanguard had net investor inflows of $277 billion, of which all but $20 billion was directed to its lineup of index funds. Only $244 billion was placed in all other fund families combined.

The idea behind index funds is simple. Because markets are relatively efficient, over a lifetime of investing you are better off “approximating or equaling” the market than trying to “beat” it with your stock market investments. It is my core investing principle.

Index funds have some inherent features to their construction that gives them a leg up on the competition. First, the cost structure of an index fund, otherwise known as its “expense ratio,” is significantly lower than the average “actively” managed mutual fund. Every dollar you don’t pay a stock picker is a dollar you can sock away for your retirement, and over time, those dollars add up.

On Finance: Understanding the Advantages of Index Funds

Second, if you are investing in a taxable account, index funds are generally more tax-efficient than actively managed funds. Because index funds track a specific benchmark, the “turnover” within the fund (a metric showing the number of times a stock is bought and sold) is greatly reduced, keeping one’s capital gains tax liability to a minimum.

Third, an index fund provides you the confidence that you are maximizing your return potential in the stock market. Although Wall Street wants you to think that the goal of investing in the stock market is to “beat the market,” the blunt reality is you should be more concerned about how much you will “underperform” a benchmark.

Index funds are all the rage. But index funds are not some magical investing tool that will make your life any easier in addressing the important components of your financial plan. Heck, I could invest in a low-cost, low-turnover, actively managed fund and basically expect the same results as an index fund over the next 20 years.

The elusive, magical investing tool can only be found in you, in your ability to sock away enough money to reach your retirement goal, in your ability to live within your means throughout retirement, and in your capacity to stay committed to your investments during the next bear market when financial pundits are predicting an end to the world.

When you own an index fund, although the underperformance of your fund compared to its benchmark is minuscule (limited to the expense ratio of the fund), the underperformance of your account can be significantly greater if your buy-and-sell decisions are a reaction to the daily news and short-term volatility of the market. Let’s take a closer look.

The year 2016 was a good year for Vanguard, and it was probably a pretty good year for your portfolio as well, with the S&P 500 Index up almost 12 percent for the year. Most of us have probably forgotten, though, that the first six weeks of 2016 generated a decline of 10 percent, the worst start to a new year in stock market history.

I won’t ask how you reacted to that short lived sell-off, but investors as a whole were massively “uncommitted” to their stock market investments. Morningstar Inc. reported a net “outflow” of domestic equity mutual funds of $19 billion during the first two months of 2016.

Since then, the S&P 500 Index is up over 30 percent. I suspect that many of those sidelined dollars either remain on the sideline, or have been reinvested into the market at much higher levels.

Your tenacity to stay committed to your stock market investments throughout the next bear market is critical to you capturing its return long after that bear market has faded from memory. If you can’t endure a 25 percent decline to your stock market investments, either financially or emotionally, the time to reallocate some stocks to bonds is now, not after the market has dropped 10 percent or 25 percent. That is the time to buy more stocks.