Index Funds, Not Actively Managed Funds
April 11, 2009 by Miranda Marquit
Filed under Finance
I’m a boring investor. My investing pretty much consists of cash investments and retirement account investing. Sometimes I vary it up with a little buying on stock market dips and selling on rallies, and I have started doing a little bit with Lending Club, but for the most part I’m all about the boring, passive stuff. I’m especially fond of index funds.
Index funds instead of actively managed funds
The idea behind actively managed funds is that there is someone — an “expert” — who chooses which stocks go into the fund. This expert is paid a fee for managing the fund. Managed funds often boast that they achieve such spectacular returns that it offsets the cost of the fees you pay. Unfortunately, this claim is not always true. Oblivious Investor makes this excellent point about earnings from the stock market:
Let’s imagine that over the next decade, all the publicly owned companies in the world economy earn a grand total of $800 trillion. As a result, the most that all of the shareholders of those companies could earn on their (stock) investments over the decade would be $800 trillion. Simple so far, right?
However, in reality, the total amount earned by the whole group of investors would be significantly less than $800 trillion. Why? Because of investment costs–things like brokerage fees and commissions, mutual fund sales loads, mutual fund operating expenses, and so on.
Managed funds can be among the most expensive investments. So, what if you cut out the middle manager and just picked your own investments? Well, stock picking is chancy at best. Instead, consider index funds.
Index funds
Index funds are basically funds that include every company on an index. There are funds that represent the the Dow, the S&P 500, indexes created to follow green companies and small-cap indexes that follow small businesses. And there are many more beyond these. There are innumerable chances for you to invest in index funds. And your returns are based on the overall performance of the whole index. This means that if you invest in an index fund that follows the Dow Jones Industrial Average, over time you gain what it does. And you pay fewer fees, since these aren’t actively managed funds.
Index funds are the ultimate in passive investing. You gain when the stock market does, and you can buy more shares when the stock market is lower. You pay fewer fees, and you don’t have to try and figure what which stocks are going to beat the market. On the other hand, you are unlikely to see really dramatic gains. But for a boring investor like me, big gains aren’t really necessary. All I ask is that I earn enough. And index funds provide me with more than enough.
Do you like index funds?
image source: Kowloonese via Wikimedia Commons
Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions and any loss that may result from your decisions.
“But for a boring investor like me, big gains aren’t really necessary. All I ask is that I earn enough. And index funds provide me with more than enough.”
Reminds me of one of my favorite Jeremy Siegel quotes, “You don’t have to beat the market to do well in the market.” :)
I’m not sure why people invest in actively managed funds. Both index funds and actively managed funds have the influence of people (i.e. the Dow Jones is a FOR profit company and this is what a lot of the index funds are based on). It is my IMPRESSION, I don’t know the numbers, that actively managed funds buy and sell stocks much more actively than index funds.
I completely agree, with a few rare exceptions.
@HIB: You are right that actively managed funds buy and sell more than index funds. This is because a fund manager is active in deciding which stocks to include. An index fund is something most people just invest in on their own because it includes what’s on an index. Only when a stock is removed from an index for some reason is it taken out of an index fund.
@Vered: Great minds…
I think you leave out the main premise (other than low cost) behind advocates of index fund investing– asset allocation. For example a taxable, balanced portfolio might look something like:
Bonds
Vanguard Total Bond ETF (BND) 15%
iBoxx $ Investment Grade Corporate Bond Fund (LQD) 5%
Nuveen Select Tax-Free Portfolio 2 (NXQ) 10%
Nuveen Municiple Value Fund (NUV) 10%
Stocks
Vanguard Total Stock Market Index ETF (VTI) 6%
Vanguard Value ETF (VTV) 6%
Vanguard Small-Cap ETF (VB) 6%
Vanguard Small Cap Value VIPERs (VBR) 6%
Vanguard REIT Index ETF (VNQ)3%
Vanguard FTSE All-World ex-US ETF (VEU) 6%
I-Shares MSCI EAFE Value Index (EFV) 12%
Vanguard FTSE All-World ex-US Small-Cap ETF (VSS) 6%
Vanguard Emerging Markets ETF (VWO) 6%
I-Shares S&P World ex-US Property Index (WPS) 3%
Yes, it’s biased toward value and small cap, but odds are those two areas will out-perform over the long-term. And yes, it contains two non-index, low-cost municipal bond funds to save on taxes.
The more adventurous can add a small portion of gold (GLD or IAU) or a general commodities fund (RJI).
The are some good active funds that have outperformed the market over the long-haul with less risk, but you are dependent on star-managers and often get nasty tax surprises near the end of December.
Great quote! I love that one, too. There is no reason to think that you have to do amazing things against the market. To me, it’s all about reaching my personal goals.