If you’re looking to invest in the stock market these days, chances are you’ve been told to put your money in an index fund. What does that mean? Basically, an index fund is a fund that operates under a set of principles, i.e. this fund is going to invest in large cap companies or small cap or emerging markets. Then it buys a basket of stocks from that category. As an example, take Fidelity’s 500 Index fund (stock symbol FUSVX) . It’s a large blend fund, so that means it owns BIG companies–Apple, Microsoft, Berkshire Hathaway, Exxon. See the trend? The only thing these companies have in common is size. The fund holds these companies and almost never sells the holdings, unless the company falls out of the category.
How does this differ from “actively managed funds”? Actively managed funds also have a mandate–they can be in sectors like energy or telecommunications–or they can be organized by size–small cap, mid cap, etc. The management team of that fund will move in and out of positions based on their research. Actively managed funds charge fees for their management, sometimes quite large ones (hey, they gotta pay for that Greenwich McMansion somehow!). Also, when they move in and out of positions, they trigger taxes which you will have to pay at the end of the year. Average cost for managed fund is 1.15%. For an index fund it’s .10%
Those numbers may seem small…but John Bogle, the recently head of Vanguard who came up with the idea of index funds did a study over a 16 year period and the difference in a hypothetical $10k investment over that time period was 90k vs. 49k. Those percentages matter!
Initially, the mutual fund industry pooh poohed the index fund idea. Today, they represent 20% of the entire industry and that number continues to grow. For an excellent discussion of the benefits of actively managed funds vs. index (or passive) funds, https://us.spindices.com/spiva/#/about, a website maintained by the S&P DOw Jones Indices. Most eye opening stat–76.49% of large cap funds underperformed the S& P index over the last five years.