Index Funds: Why Choose Anything Else?

Like many other investors, J.D. and I are fans of taking the slow, sure path to wealth. We invest much of our money in index funds. An index fund is a low-maintenance, low-cost mutual fund designed to follow the price fluctuations of a broader index, such as the S&P 500 or the Wilshire 5000. They're boring investments, but they work. (If you're investing for the excitement, you're doing it for the wrong reason.)

Because of their low costs, index funds have been shown over and over to dominate the majority of their competition. Yet many investors shy away from index funds with the reasoning that “the stock market is too risky for me.”

People seem to think that index funds are simply mutual funds that track the U.S. stock market. And that's not particularly surprising given that S&P 500 index funds are:

  • the largest index funds,
  • the index funds mentioned most frequently by the media, and
  • the index funds most likely to show up as an choice in your 401(k).

But there are all kinds of index funds aside from those that track the S&P 500. There are bond index funds, real estate index funds, commodities index funds, international stock index funds, and so on.

In other words, you can create a thoroughly diversified portfolio using nothing but index funds.

In fact, I'd suggest doing exactly that. By created a diversified, all-index fund portfolio, you'll achieve a list of benefits relative to other types of portfolios.

Lower Risk
Which sounds safer: Having the stock portion of your portfolio invested in 10 different companies, or having the stock portion of your portfolio invested in several thousand companies from more than 10 different countries? I know some people disagree, but to me it's a no-brainer.

By constructing your portfolio from index funds, you'll achieve far greater diversification (and therefore be exposed to less risk) than you would if you constructed your portfolio from individual stocks and bonds.

Lower Costs
Both common sense and historical data tell us that one of the best ways to improve investment returns is to reduce costs. Conveniently, index funds carry significantly lower costs than actively managed mutual funds. For example:

  • Vanguard's Total Bond Market Index Fund has an expense ratio of 0.22%. That's less than one-fourth of the average expense ratio among bond funds (1.04%, according to Morningstar's Fund Screener tool).
  • Vanguard's REIT Index Fund has an expense ratio of 0.26%, or less than one-fifth that of the average real estate fund (1.45%).

It's quite possible that you could cut your total costs by 1% or more. And while 1% per year may not sound like much, it can really add up over an extended period.

Lower Taxes
Index funds have much lower portfolio turnover than other mutual funds. (That is, they buy and sell investments within their portfolios far less frequently than actively managed funds do.) This makes them more tax efficient than other mutual funds for two reasons:

  • The capital gains they distribute are primarily long-term in nature (and thereby taxed at a lower rate than short-term capital gains), and
  • Their capital gains distributions are minimized, meaning that you get to defer a significant portion of taxes until you sell the fund.

Added Bonus:
You'll understand what you own. With an actively managed mutual fund, you never know exactly what the fund manager is investing in. With index funds, it's all out in the open.

Do you (like both me and J.D.) have a portfolio made up primarily of index funds? If not, why? Is there a particular concern that's holding you back?

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RJ Weiss
RJ Weiss
10 years ago

I find it ironic that after having read a bookshelf full of investment books and spending hours upon hours looking for the perfect investment, I choose a target retirement fund composed of index funds.

Sometimes the simplest answer is the best.

Suzanne
Suzanne
10 years ago

I have all of my investments in index funds, including the ones Mike mentions (thanks Mike!). For those who have the time, inclination, and education to research and track individual stocks, more power to them. They can do very well. I don’t trust myself, or anyone else for that matter, to consistently beat the market, so index funds were the answer for me. With their low fees and high returns, it seems like a no-brainer.

Lesley
Lesley
10 years ago

What about for Canadians? From what I’ve been able to learn so far, there aren’t really a lot of options in this regard.

Mike Piper
Mike Piper
10 years ago

Lesley: You may want to look into exchange traded funds (ETFs). They’re essentially index funds that trade like regular stocks and can usually be purchased from any broker.

Mike from Four Pillars (a Canadian personal finance blog) has covered the topic pretty well in these two posts:

http://www.four-pillars.ca/2008/02/12/index-funds-vs-etfs/

http://www.four-pillars.ca/2008/03/28/strategies-for-etfs-and-index-funds/

Ric
Ric
10 years ago

I think index funds are great.

I also think that for the extra cost a fund like one of State Farm’s Lifepath funds, really a barclays global lifepath fund sold in a size that the average investor can buy, is the real answer.

No investor emotion is involved when choosing to move funds towards lower risk as time goes on, no choosing when to move funds, no decisions on rebalancing.

Really a good target date fund would work best for about 95% of America.

Unless you have Time, Inclination and Education to be an expert!!!

Ric

Four Pillars
Four Pillars
10 years ago

Thanks for the mention Mike.

Lesley – you should check out iShares.ca for etfs in Canada. Alternatively you can look at Vanguard etfs – both the iShares and Vanguard etfs along with others can be purchased in a normal discount brokerage account in Canada.

If it’s low cost index funds you want (which are a bit easier) then look into TD efunds which you buy from TD.

Russ
Russ
10 years ago

Because index funds are not actively managed you are exposed to ALL the price fluctuations of the broader market. The benefits of buying low and selling high are lost on these funds because there is no one there to do it. I also don’t have time to research individual stocks or the knowledge to even know what to look for. Which is precisely the reason I pay a fund manager to do it. He has a record of crushing the S&P index and continues to do it for a modest 1% fee which I’m happy to pay. With index funds… Read more »

Russ
Russ
10 years ago

I hope my comment didn’t come off too negative. I think index funds have a place, but in using them you have to take the good with the bad. My point is that a fund manager has a very real ability to filter out the bad and look for the good. While at the same time taking advantage of market price fluctuations.

Matt
Matt
10 years ago

I don’t think your comment came off as too negative, but it certainly caught me by surprise.

I’ve NEVER heard of a manager who has CONSISTENTLY beaten the S&P index — so perhaps you’re fund manager is the first to do so.

Either way, post the fund and let’s all have a look.

Luke
Luke
10 years ago

Could you explain the tax implications? You touched on them briefly in this article. I haven’t done any investing outside of my 401k, and to be quite honest I have no idea how taxes work for something like this. Given your strategy of investing in index funds, and assuming this is not retirement investing (like a tax sheltered 401k), what are your tax liabilities at the end of the year?

Russ
Russ
10 years ago

FAIRX — The fairholme fund. Bruce Berkowitz is the manager.
http://www.fairholmefunds.com/

EvilDave
EvilDave
10 years ago

I agree with the other commenter that I would like to see a discussion about funds vs. ETFs.

I find the load/no-load, maintenance reqs, etc. of funds difficult to deal with and find ETFs much easier to understand.

Suzanne
Suzanne
10 years ago

@Russ, is that the one Jim Cramer used to manage? How has it done since he left?

Russ
Russ
10 years ago

From 12/29/99 when the fund was opened Through 12/04/09 FAIRX has returned 237.61% while the S&P 500 index is NEGATIVE 9.96%. Neither calculation takes re-invested dividends into account.

timmer58
timmer58
6 years ago
Reply to  Russ

Russ is correct but only a small group of managers can beat the index, and an even smaller group can do it regularly

Russ
Russ
10 years ago

@Suzanne, NO it is not the fund Jim Cramer used to manage. Also, I didn’t intend to push a specific fund, but Matt asked for an example.

Matt
Matt
10 years ago

Can somebody clear this up for me?

The fund that Russ posted has a 1% expense ratio.

For the sake of argument, the Vanguard 500 index fund has a 0.18% expense ratio.

So for Russ’s fund (FAIRX) to outperform the Vanguard 500 index fund, the fund manager must deliver approx. FIVE times better results than the index fund.

Is that correct? (I’m certainly no math genius so if this is all wrong let me know.)

Four Pillars
Four Pillars
10 years ago

Matt, the fund manager has to outperform the index by 0.82% to make up the extra expense.

Using ratios isn’t really correct in this example.

Nicole
Nicole
10 years ago

Yes. 100% index or ETF. Just added a foreign index this year for the first time for more diversification. Actually, the 529 is in mutual funds because there’s a limited choice set there.

I always find it funny when I’m logging into etrade and it suggests I read what the motley fool recommends for individual stock picks. The motley fool is who originally convinced me to just stick with index funds. But I guess boring strategies are harder to keep selling unless you’re Dave Ramsey, even if they work.

Mike Piper
Mike Piper
10 years ago

EvilDave: Unless you’re planning on doing things like buying on margin or buying/selling options (both of which you can do with ETFs but not with regular index funds), the primary difference between ETFs and index funds is costs.

The two articles linked to above from Four Pillars do a good job of explaining it, or you can take a look at this article I wrote a while back.

Mike Piper
Mike Piper
10 years ago

Luke: Regarding the tax implications of index funds (as compared to other mutual funds) in a taxable account, this article may be of use: http://www.obliviousinvestor.com/tax-efficiency-of-index-funds-and-etfs/

If you have specific questions beyond that, let me know, and I’ll do my best to answer them.

Erica Douglass
Erica Douglass
10 years ago

No, I don’t invest in index funds. I hand-select dividend stocks and do the research. I understand a lot of people don’t think they have the time or knowledge to do this, but it only takes me a few hours a month — less than I’d spend watching one 1-hour TV show every week. And I get to invest in companies I understand. Beating the average return is not my goal; my goal is to invest in companies with sold track records of growth. That said, I’ve handily beat the S&P 500 since I realigned my portfolio to individual stocks.… Read more »

JT
JT
10 years ago

Yes, I use a targeted index fund for all my retirement contributions. My future is in Fidelity’s hands and the folks who manage that particular fund. I’m nearing 30 so I have 30 – 35 years until retirement (I think/hope).

chacha1
chacha1
10 years ago

I also have never invested in index funds, but then for the past 20 years I’ve had a very high risk tolerance. Not so much going forward … I still have a 20+ year retirement horizon, but: My hand-picked stocks have recovered 100% from their 11/08 low point. I think the markets are going down again soon, so I plan to sell out *very* soon while my stocks are high, then roll over the cash in my two accounts (a 401(k) from a previous employer, and a rollover IRA from a 401(k) from another employer) to the 401(k) at my… Read more »

Russ
Russ
10 years ago

@Erica, I think that is great. I think the idea that no-one is capable of determining which companies are more likely to do well and which companies are likely to fail is hogwash. A fund manager’s job is to do the research, look at earnings statements, balance sheets, growth prospects, scope out the competition. As an investor you are an owner — owners should know exactly what they are buying. Then after they’ve done the research the second part of their job is to get the best price. I think it is a bit unrealistic to expect most people to… Read more »

Mike Piper
Mike Piper
10 years ago

Russ: What is your method for determining (ahead of time, of course) which fund managers are likely to outperform the market?

Russ
Russ
10 years ago

Track record and investment philosophy. I didn’t buy into FAIRX at the beginning. Or more specifically, a track record of sticking to their investment philosophy. I don’t think this concept is very radical, or even terribly difficult. Look at what philosophy the most successful investors of our time have. You don’t see Warren Buffet buying index funds (though he does recommend them for others, ironically). If someone like that can consistently find companies that do well and get them at good prices, and if I can pay them to do it for me, well thats a win-win situation.

Paul Williams @ Provident Planning
Paul Williams @ Provident Planning
10 years ago

@Ric (#5):

You could just go with a Vanguard Target Date fund and you won’t have to pay any additional fees at all. It’s actually quite ridiculous that State Farm or Barclays charge extra for their “glide path” funds. It doesn’t take that much extra work, and you can just go to Vanguard to get the same thing for no extra charge.

Aolis
Aolis
10 years ago

There is an army of financial planners that are paid commissions to get you into actively managed mutual funds. They get little money for low fee index funds so they don’t sell them. Instead they encourage their clients to chase higher returns.

In Canada, TD e-Series funds are an excellent choice.

http://www.tdcanadatrust.com/mutualfunds/tdeseriesfunds/index.jsp

Greg
Greg
10 years ago

Russ- I look forward to your answer to Mike Piper’s question. You’ve done pretty well to date with that investment. It’s possible you’ve gotten lucky and hit on one of the small minority of actively managed funds that do well; it’s much more likely that your future holds a painful lesson in regression to the mean. In addition, I hope you understand that FAIRX is not a domestic, large-cap fund, so comparing its performance with the S&P 500 index is specious. You should also know that your statement that “index funds are negative over the last decade” is wrong. You’re… Read more »

Chance
Chance
10 years ago

You made a terrific point about being able to create a well diversified portfolio using index funds. All too often when people hear “index fund” they think of a fund that simply mimics the entire stock market. There are many, many ways for us to cater our portfolio to our risk preferences using the slew of index funds now available. Great post!

Stuart
Stuart
10 years ago

I agree that index funds are better investments than mutual funds. However, I still feel they are less cost effective than simply owning a pool of stocks yourself. This will of course depend on the size of your portfolio.

I am a fan of buying the strongest lot of an index funds holdings and sitting on them. Take a look at the relative strength of each. These stocks tend to decline less than the average during a downturn and perform better durning a bull run.

Faculties
Faculties
10 years ago

We will all be able to find actively managed funds that overperformed index funds — if we look back after the fact. Since index funds reflect the market average, many managed funds will do better, and many managed funds will do worse. Index funds are a way of mitigating the risk that the managed funds or stocks you pick may be on the “worse” side of that divide. You go for the average instead of betting on your ability to identify ahead of time which funds or stocks are going to outperform the average. As I say, it’s easy to… Read more »

Investor Junkie
Investor Junkie
10 years ago

Like Erica I think there is a roll of stocks in one’s portfolio. Yo do have some advantages in stocks that a mutual fund manager does not. Though, IMHO specific stocks should be a small less than 15% of your entire portfolio. Also it should be stated not everyone cares to read or will understand a financial statement, so they might be better off investing in index mutual funds or ETFs. For me I put my stocks outside of my retirement funds. I use indexing for all retirement. Partly because there is not choice (a good portion is in 401ks),… Read more »

Sierra Black
Sierra Black
10 years ago

This is great. For the truly clueless among us: how can I get started investing in an index fund? I’m self-employed, so it’s not like I can call HR and make it happen.

Russ
Russ
10 years ago

Greg- OK, fair enough I did not mean to imply that FAIRX has outperformed all index funds. And my statement that index funds are negative certainly does not apply to all index funds, I was talking about the S&P 500. I apologize for being misleading. The S&P 500 is a very common benchmark, pick another and we can go from there. My point of comparison was to show that in the face of a market correction, a manager can add value. I’m sure we can find other investments that have done much better than FAIRX, and I certainly did not… Read more »

Hole
Hole
10 years ago

I think Russ has identified my concern with index funds. Since I am very young, and over the course of the next 30 or so years, I don’t want to miss out on the opportunity of greater returns.

With that said, I am more likely to choose index funds because of their simplicity.

Kim
Kim
10 years ago

Hi all – I’m Canadian, just in the process of learning to be an independent investor and I’m using the free practice demo at Questrade, and other Canadian online brokerage sites. I’m interested in dividend and index funds. I notice that I can’t “buy” any of the Vanguard 500 Index fund. In fact I get told the VFINX symbol is “invalid”. Same with Manulife Financial (MFC-T). Please don’t laugh me out of the park, but can anyone tell me what the problem is? Is it because they’re US funds? Thanks.

Julie Hocking
Julie Hocking
10 years ago

So, right now, I’m in Vanguard, Total Stock Index Fund, Total International Index Fund, and Total Bond Fund, in proportions appropriate for me.
Should I be further diversifying into Small CapIndex Funds, Large Cap Index Funds, and goodness knows which other Index Fund categories? Or will I be “OK” with the three I’ve picked? 🙂

Four Pillars
Four Pillars
10 years ago

@Kim – Canadians can’t buy American mutual funds. And in the spirit of free trade, they can’t buy ours either. 🙂

Foreign ETFs on the other hand can be purchased in either country. You can buy Vanguard ETFs- that’s what I have in addition to some iShares etfs.

The symbol for Manulife is MFC.to (I don’t think the caps matter). It should be there.

Mike Piper
Mike Piper
10 years ago

Sierra Black: If you’re self-employed, you can set up your own retirement plan. This article explains your different choices:
http://www.simplesubjects.com/tax/business-retirement-plans-sep-vs-simple-vs-keogh.html

For most people, either a SEP IRA or a Solo 401(k) is the best choice. Vanguard (my index fund provider of choice) offers both at a very low cost.

Mike Piper
Mike Piper
10 years ago

Julie: You already have an extremely well diversified, low-cost portfolio. That’s pretty good in my book.

That said, others would argue that you can gain additional diversification by picking up some small-cap funds and/or value funds. If you’re interested in adding funds to what you already have here are my general suggestions for the priority in which to pick them up.

MoneyEnergy
MoneyEnergy
10 years ago

I own a bit of everything. I have two ETFs, a couple index funds (Canadian), but usually I hand-pick good dividend stocks and do my own research. I like using ETFs to cover broad market areas that I don’t know as well or that are subject to more volatility, like commodities. I also prefer hand-picking my stocks because I like to assert control over where I’m putting my money, and you don’t get that with broad-based index funds/ETFs – you will also be investing in weapons companies, alcohol, fast food and tobacco. If you’re fine with that, that’s your decision… Read more »

Mark Wolfinger
Mark Wolfinger
10 years ago

“Slow, sure path to wealth.” Nonsense. It’s slow all right, but where does ‘sure’ come into the picture? Where’s the guarantee? It’s propaganda. When you say that index funds ‘work’ you mean that you can anticipate performing on a par with the major market average that your fund mimics. Why is that good? I agree that indexing seems ‘good’ because it is far, far better than using actively managed mutual funds. Those are for the ignorant investor. Those are for clients of financial advisors. But just because it’s better than mutual funds, that does not make it good. It does… Read more »

Doctor Stock
Doctor Stock
10 years ago

Index funds are a great tool… however, investors can create their own “index” choosing the strongest stocks and leaving the laggards behind. Beat, not meet, the index.

Peggy Kessinger
Peggy Kessinger
10 years ago

Passively managed index funds provide an excellent foundation to diversify your portfolio.

ETFs have really come into their own and can provide additional cost effective options for more segmentation.

However, the key is not simply a buy & hold strategy, but one the involves re-balancing back to a target portfolio on a regular basis.

Alex
Alex
10 years ago

Keep in mind for every managed fund that has outperformed an index you could have easily picked out several that underperformed it. Has the fund outperformed in the past? How long will it continue to outperform? Will you have to change to a different fund? It underperformed for the first time should I jump ship? I don’t think the market is fully efficient, a good fund manager can outperform an index fund. But when you are looking at a timeline of investing for decades and decades you can bet they can’t outperform every time. One bad year can wipe out… Read more »

Edwin
Edwin
10 years ago

Index funds are a great way for a passive investor to eliminate the risk involved in investing and only leave themselves the systematic risk.

They can also be a great way to diversify a portfolio for less risk. Active investors (ones that read annual reports, pay attention to company news, etc.) may not be as inclined to invest as much into index funds as the passive investor but they surely have their place.

Meghan
Meghan
10 years ago

I started investing a little over a year ago and have decided to focus on index funds in my portfolio. My question though is what indexes? I’m Canadian and our mutual funds tend to have higher MER’s, even index funds. So I decided to go with ETFs because of the lower fees. But holy smokes, it seems like they have an index for everything these days!! I even read that some company has come up with “faith-targeted ETFs”. I just finished The New Coffeehouse Investor and Bill Schultheis talks about some of this, but I’d like to hear how other… Read more »

jonasaberg
jonasaberg
10 years ago

One of the major advantages of mutual funds is that you can invest comparatively small amounts per month. I don’t know how it works in the US but here in Finland it’s not very cost effective to buy stocks or ETF’s with small amounts. You need to invest at least 600-1000 in one go to keep the costs down. Most people don’t have that kind of money to spare regularly. Most index funds here aren’t better, as they require a “startup capital” of up to 10,000€, which rules them out for most people. If you want to invest maybe 50-100€… Read more »

Rob Bennett
Rob Bennett
10 years ago

I think index funds are wonderful. I am personally inclined to limit myself to index funds (I don’t today have the time available to pick stocks effectively) But I don’t at all agree that investors should permanently limit themselves to index funds. One big problem with indexing is that it makes stock investing too artificial an enterprise. Indexers have a strong inclination to dogmatism (trust me!). I believe this problem is rooted in the reality that you don’t need to understand what it is you are investing in when you invest in an index. To pick a stock, you are… Read more »

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