As you embark on your journey to build wealth through mutual funds, you may wonder which to choose: actively managed mutual funds or passively managed mutual funds. If you are new to investing, the idea of a passive fund might seem odd, maybe even lazy. In fact, the idea of paying a trusted fund manager to monitor and trade your investments might seem like a better option if you're not quite sure what you're doing, but the choice isn't quite that simple.
Here are some reasons why you might want to think about passive index fund investing as a long-term strategy.
What Is An Index Fund?
Before you add an index fund (or any other investment) to your portfolio, you should know what it is and how it works. An index fund is a mutual fund or exchange-traded fund (ETF) designed to mirror the performance of a major index like the Dow Jones Industrial Average, S&P 500, or Nasdaq. When you purchase a share in one of these funds, you are actually buying a small piece of a number of stocks at once.
Index funds are passively managed. This means the fund manager picks an index to track and then simply copies its holdings. They may check in when the index has changed its holdings, or some other major event, and rework the balance of your holdings. But for the most part your portfolio will stay as it is.
For instance, an investor that buys a Vanguard S&P index fund designed to mirror the S&P 500 will adopt the S&P risk. When the S&P gains, then the investor's S&P index fund will rise by almost exactly the same amount. When the S&P falls, their portfolio will suffer the same decline.
Note
In funds that are actively-managed, the fund manager plays an active role in choosing stocks. They study many single stocks (and the market as a whole) based on complex factors, and make choices and trades to try and do better than an index. Of course expert advice comes with a price tag.
How Index Funds Can Help You Skip the Analysis
Index funds are ideal for those who are new to the market, and who may lack the skills or knowledge to assess a company's finances or compare corporations. With an index fund investment strategy, you don't need to pour over income statements from a balance sheet. You don't need to calculate discounted cash flows or any analysis ratios. In fact, if these terms seem daunting, rest easy because you can simply follow the lead of an index.
Diverse Holdings
The point of watching all these metrics in the first place is to avoid placing your money with risky companies. With an index fund, you don't need to worry too much about the risk from a single company. This risk is reduced by the fact that you're buying dozens or even hundreds of companies with a single fund share.
How Index Funds Can Help Lower Your Costs
Actively managed mutual funds rely on a team of managers and analysts that decide what trades to make. All of these people must get paid, and even if a single fund manager handles most of the duties, the fees will still add up. Your costs amount to a percentage of the fund's assets each year, and they are taken from the fund before you receive your share. This is known as the expense ratio.
Small Expense Ratios
Index funds may have a manager, but that manager will do far less. All they have to do is check in on the holdings form time to time, and ensure that they still mirror the underlying index. Since they do less, these managers get paid less. This means that you can reduce the amount of your portfolio that goes into a fund manager's pocket. This effect compounds in the long run.
Note
For a closer look at fees, take for instance Vanguard's passive index fund that tracks the S&P (VOO). The expense ratio of this ETF is only 0.03%. Compare that to Vanguard's Growth and Income Fund (VQNPX), which attempts to beat the S&P 500 and comes with an expense ratio of 0.33%.
No Broker Fees
Another way that index funds save you money is how they reduce brokerage commissions. If you wanted to replicate the portfolio of an index fund (without simply buying shares in the index fund), you would have to buy all those companies on the index, one by one. That could mean dozens or hundreds of trades, which would not only cost a large amount of cash, but would also be charged a broker's fee for each trade.
How to Combine Dollar-Cost Averaging With Index Funds
Index investing works well with a dollar-cost averaging strategy. This is a tactic that consists of making small and steady investments over the long-term, and sticking with it, no matter how the market is doing. In practice you might buy a few shares of a single stock (or fund) at frequent intervals. When stocks are up, you buy. When stocks are down, you buy. The goal is to reduce risks related to market timing by investing regardless of how stocks are performing.
This concept of spreading market timing risk is much like that of spreading the company-specific risk. Combined, even the most inexperienced investor can develop a well-balanced portfolio that doesn't expose itself too heavily to any one risk.
Key Takeaways
- Index fund investing uses passively managed funds to invest in major stock indices.
- You won't need an in-depth knowledge of accounting, financial theory, or portfolio policy, to invest in index funds.
- You can count on a diverse array of holdings, since index funds contain dozens or hundreds of companies. This diversification reduces company-specific risk.
- Index funds have very small expense ratios, which provides a major edge over actively managed funds. The money you save on fees will compound over time, and add to your fund's gains.
FAQs
Mutual funds and exchange-traded funds (ETFs) have many different varieties of low-cost index funds. They have lower expenses and fees than actively managed funds. Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market.
Why invest in low cost index funds? ›
Diversification: Investors like index funds because they offer immediate diversification. With one purchase, investors can own a wide swath of companies. One share of an index fund based on the S&P 500 provides ownership in hundreds of companies, while a share of Nasdaq-100 fund offers exposure to about 100 companies.
Why do investors find indexes useful? ›
Indexes are useful for providing valid benchmarks against which to measure investment performance for a given strategy or portfolio.
Why does it cost less to run an index fund? ›
They're cheap to run because they're automated to follow the shifts in value in an index. However, don't assume that all index mutual funds are cheap. They still carry administrative costs. These costs are subtracted from each fund shareholder's returns as a percentage of their overall investment.
What is the main advantage of index funds? ›
There are also several advantages to index funds. The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. Exchange traded funds (ETFs) are often index funds, and they generally offer the lowest fees of all.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Do billionaires invest in index funds? ›
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
What is bad about index funds? ›
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
Why choose an index fund over an ETF? ›
You may be able to find an index mutual fund with lower costs than a comparable ETF. Similar ETFs are thinly traded. As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high.
Is there a downside to index funds? ›
Disadvantages of index funds. While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
What is the cheapest S&P 500 index fund? ›
Our recommendation for the best overall S&P 500 index fund is the Fidelity 500 Index Fund. With a 0.015% expense ratio, it's the cheapest on our list. And it doesn't have a minimum initial investment requirement, sales loads or trading fees. Over the last 10 years, FXAIX has returned an annualized 12.02%.
Is there anything better than index funds? ›
Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.
What is a low-cost index fund? ›
Low-cost index funds are an inexpensive way for people to build a diversified investment portfolio. These funds are suitable for both new and experienced investors, and the best low-cost index funds allow you to meet your investment goals while aligning with your risk tolerance and investment time horizon.
What are the pros and cons of an index fund? ›
Advantages and Disadvantages of Index Funds
| Pros | Cons |
|---|
| Lower fees than actively managed funds | Little downside protection (especially during bear markets) |
| Lower risk than actively managed funds | Lower return potential |
| Hands-off; little research/knowledge necessary | No control over fund composition |
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Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Is it better to invest in index funds or stocks? ›
The biggest difference between investing in index funds and investing in stocks is risk. Individual stocks tend to be far more volatile than fund-based products, including index funds. This can mean a bigger chance for upside … but it also means considerably greater chance of loss.
Why index funds are better than mutual funds? ›
Index funds tend to be low-cost, passive options that are well-suited for hands-off, long-term investors. Actively-managed mutual funds can be riskier and more expensive, but they have the potential for higher returns over time.
Why are index funds better than hedge funds? ›
A hedge fund is less transparent to its investors, who may only get intermittent updates from the manager; an index fund is easy to understand, and its performance and total value are updated each day the markets are open.
