One of the most popular investment vehicles in use today is the index fund. Recently, the assets under management in the index fund category surpassed that of which is managed in active mutual funds.
That said, what is an index fund? How did it come about? What are the characteristics of an index fund?
What is an index fund?
In its simplest form, an index fund is a passively managed mutual fund that tracks an index. It started out by tracking the S&P 500 and for a long time, that’s all these funds tracked.
Now, there are index funds for anything. The DJIA, biotech sector, micro-cap stocks, the list goes on and on.
In terms of stock market history, index funds aren’t old. The first index fund was created by Vanguard in 1975.
Through the late seventies and into the eighties, the index fund failed to catch on. It seems that only in the last decade or two, index funds were recognized as compounding machines and grew in popularity.
So what’s the big deal? Why are these investments so popular? What are the advantages and disadvantages?
Pros
- Low maintenance – Similar to a target-date fund, in the sense that you can invest a percentage of your portfolio in a single index, and leave it for an extended period of time. However, these funds won’t reallocate and shift from stocks to bonds, that’s on you.
- Low cost – Most index funds are low cost. I’m talking about the general funds that track large indexes. It also makes a big difference if the fund is with a big fund family or not. The big fund companies have more capital and more products, so they can offer for less. Also, as a general rule, the more specific an index gets, the higher the expense ratio.
- Participation in the broad market – you have the chance to grow your principal (original investment) by participating in the potential growth of the stock market
Cons
- Concentrated index – most index funds are market cap-weighted, which means the larger companies make up a greater portion of the index. That provides you less exposure to smaller companies AND can leave you concentrated in one industry. Four of the top five companies by market cap are tech companies.
- You ride the index up, and down. When the stock market tanks, there’s no protection if you invest in an index. For example, during the Great Financial Crisis, the S&P 500 lost 55%. The Vanguard S&P 500 index (VFINX) lost 55% from peak to trough.
Commonalities with active funds
Active mutual funds and passive index funds do have similar characteristics.
- Potential growth – Each of these has the chance to grow and compound over time. History shows that passive has a leg up in this category, but a portfolio manager of an active fund could outperform the index
- Target date funds – I briefly mentioned these before, but you pick a date in which you plan to retire. For example, 2040. You would then pick a 2040 target-date fund. At this point in time, the fund would probably be allocated 80/20, stocks/bonds. As we get closer to 2040, the fund will progressively shift its allocation more towards bonds.
What I think about index funds
I’m a big fan of index funds, especially for the general public. Fees, over the long-term, are really good at eating into your returns. Selecting low-cost index funds reduces your fee exposure.
That said, I’m also a believer in active management. When the economy is booming like it has the last 10 years, index funds will win almost every time. However, when the market finally turns over, that’s where an active manager can set themselves apart.
Related reading:
The Pros and Cons of Index Investing
The Different Between Mutual Funds and ETFs
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