With investment moguls like Warren Buffet and Charles Schwab advocating for the use of Index Funds as a simple and inexpensive way to invest in equities, it’s no wonder that these investment vehicles are gaining major popularity. Understanding how these funds work and how they can save you money may provide the simple answers to investing that so many investors desperately need in an age of ever increasing options, rules, and volatility.
How Are Index Funds Different Than Other Types of Investments?
Index Funds are designed to follow a set index, such as the S&P 500 or the FTSE 100 rather than trying to beat the market by trying to cherry-pick a selection of stocks. These funds are ideal for those who want to invest but don’t have the knowledge or desire to pick stocks, want to limit transaction fees and want to avoid the hefty costs that active fund manager’s often charge. Index funds are often the ideal starting point for first-time investors and those with limited time to research investments as they are easy to understand and you don’t require oversight in the same way that a fund manager’s performance and fees need to be constantly evaluated.
Does Strong Performance Have To Come At a Substantial Cost?
Of course, performance is a big selling point for Index Funds as most generally perform as well as the index they are tracking. However the performance of any given fund is not necessarily a given. It is a general belief among investors that when markets rise, Index Funds tend to perform better than actively managed funds. However, as markets trend down, many Index Funds will follow the market down as well. Active fund managers maintain that they can avoid this downward slip by closing positions in advance of major downturns and claim that this justifies the fees they charge.
Critics note however that active management doesn’t necessarily translate to better returns. In fact, active management can and often does result in worse performance and there can truly be no certainty as to whether or not a manager will be able to outperform the market. Even reviewing a manager’s performance over a period of years can be misleading as the market can move against any trader at any time greatly skew one’s performance. While there are some very good fund managers who have actually outperformed the major indexes over very long periods of time, there are very few of these and they are often too expensive for the average investor.
A traditional active fund typically charges a fixed, up-front management fee of 5%, and then an additional 1.5 % of the fund’s value each year, regardless of performance. Conversely most Index Funds do not have any up-front fees and only carry an annual fee of between 0.25% to 1%, with some charging as little as 0.1%. Low charges keep an investors returns from being eroded, and with the compounding nature of investments, lower fees are vital for the success of a long term investor.
As with any investment strategy, diversification is always a critical safe guard. Investors should work to develop portfolios that align with their overall goals and risk tolerance. Index funds create a great starting point and can be a well placed cornerstone in any investors portfolio.