“Don’t look for the needle in the haystack. Just buy the haystack!” 

That’s John Bogle, on the importance of index funds.

John Bogle was the founder and Chief Executive of The Vanguard Group. Most of all, he was the biggest proponent of index funds.

To understand how big of a deal this introduction was, you need to know what an index fund is, and how they have helped individuals invest, over the years.

What is an index fund?

An index fund (also known as an index mutual fund) is a fund that tracks a market index. A market index is a hypothetical portfolio of stocks that represent a certain section of the stock market. Often market indices represent the stock market as a whole. For example, S&P 500 is the most popular index in the US. It tracks the 500 largest public companies in the US. When you hear people say the market was down today, they’re likely to be referring to a broad market index.

So an index fund that tracks the S&P 500 will have shares of all the 500 companies in the index. By doing so, the index fund is trying to replicate the performance of the market index.

Index mutual funds are passively managed. The funds are automated to make adjustments according to the shifts in value in the underlying companies. 

Since the funds are not actively managed, the fees tend to be lower than actively managed funds. On the other hand, actively managed funds usually have a fund manager and a team of analysts, who are constantly trying to find new opportunities, in an attempt to beat the market. As a result, they usually have higher fees associated with them.

Traditionally, there are two types of index funds – Stock index funds and bond index funds. As the name goes, stock index funds track a stock market index (like S&P 500), a bond index fund tracks a bond market index (a market index that tracks the price of bonds, like the Bloomberg Barclays U.S. Aggregate Bond Index).

Why are index funds popular?

These are some of the reasons why index funds are so popular.

Easy to invest

Most individuals put off investing because they don’t have the time to do the research that is essential in making informed investment decisions. Also, many have a hard time understanding all the jargon that comes with the stock market. So people put off investing altogether. This is where index funds come in.

Index funds provide you a hands-off approach to investing. Even if you have no clue how the stock markets work, you could invest in index funds and still get around 8%-10% return annually. Because that’s the average annual return of the S&P 500, during the last 10 years. And since the index funds by definition are the market average, that’s the return you will receive.

Low-cost index funds

This is another aspect that makes index funds so great. Index funds are less expensive compared to other funds. On average, low-cost index funds annually charge 0.02% – 0.2% of your total investment. Whereas mutual funds charge 0.5% – 2.5% of your investment.

You must be wondering why we’re losing our heads over some fractions of a percentage. Do they really matter?

You bet they do.

In fact, these small fractions can have a massive difference in the long run. Consider this; assume you invest $10,000 in two funds that charge 0.5% and 2.5% of your investment, respectively. Assuming you get an annual return of 10%, this is how your investments will look like in 20 years.

a table comparing investment growth relative to different expense ratios

As the table illustrates, the $10,000 invested in the fund that charges 2.5%, will be worth $46,022 in 20 years. Not bad, right?

Actually, it is bad.

Not in itself, but compared to the other $10,000 invested in an index fund that charges 0.5%. After 20 years, it would be worth $61,159 – a 33% improvement over the more expensive fund.

There’s another reason why passively managed index funds are the better option when compared to actively managed funds. A 2018 report from S&P Dow Jones Indices suggests that more than 92 percent of active fund managers in large companies were unable to beat the market over a 15-year period.

This means with actively managed funds, you’re paying more money, only to underperform the market.

Diversification

A major advantage of investing in index funds is that you are diversifying your investments. As I mentioned, market indices usually consist of several companies that belong to different industries and sectors. So with index funds, you’re diversified from the get-go. For example, SPY is an exchange-traded fund (ETF) that tracks the S&P 500. ETFs work basically the same way an index fund does. So when you buy one share of SPY, you own shares of 500 companies.

This immediate diversification leads to less risk. As your investment is sprawled across companies from different sectors, you’re less likely to suffer losses. And even if you do, your losses should be balanced by your gains from other stocks in the fund.

Remember the quote at the beginning? That’s another reason why investors choose index funds. Instead of looking for the next big winner among thousands of stocks (needle in hay), you can buy an index fund (the hay), and make sure that you don’t miss out on the winners.

Disadvantages of index funds

Since we talked about all the good things that make index funds a popular form of investment, I feel like we should look at the other side of the coin too.

When it comes to the demerits of index funds, these are what I can think of;

Average returns

With index funds, you’ll only ever make average returns. That is because the performance of the market index is considered the market average. Since that is the performance your index fund tries to match, you’ll end up with the same returns. So it’s unlikely that you’ll ever beat the market.

Less choice with stocks

When you invest in an index fund, you’ll be investing in several different stocks; you might be interested in some of those, not so much with other ones. Your choice is limited with index funds. You’ll likely end up owning stock you’d rather not own.

Moreover, you might miss out on certain stocks that may not be a part of any index, but you believe has a huge potential.

How to invest in index funds?

The first step to investing in an index fund is choosing one.

A couple of things to be kept in mind while choosing an index fund are expense ratio, tracking error, and the index that it tracks.

Underlying index

When you’re investing in an index fund, you’re basically investing in the underlying index. So it’s important to identify which index is worth investing in. Generally, people go with index funds that track a broad market index such as the S&P 500, or the Dow Jones Industrial Average (DJIA). You also have the option to choose indices that focus on specific sectors. Even better, you have index funds that track the index of global stocks – like Vanguard Total International Stock Market (NASDAQ: VXUS).

Expense ratio

It is the amount you’ll be charged annually, for investing in the fund. It is expressed as the percentage of the amount you invest. For example, if you invest $10,000 into a fund with an expense ratio of 0.02%, you’ll be charged $2 every year. Like I mentioned earlier, the average annual expense ratio for index funds is around 0.02% – 0.2%.

As illustrated earlier in the article, the more the expense ratio, the less the returns.

Tracking difference

Basically, tracking difference is the difference in the index fund’s performance to that of the underlying index. If a market index produces an annual return of 10%, and the index fund produces 9.8%, the tracking difference is -0.2% (9.8% – 10%).

The negative value indicates that the index fund is underperforming the market index it tracks. So when the tracking difference is positive, the index fund is outperforming the market. Usually, the tracking difference tends to be marginal.

Once you decide which index fund you want to invest in, you can open a brokerage account with, either a broker or the mutual fund company that issues the index fund. Since you’ll likely make more investments in the future, it’s better to go with the broker. Once your brokerage account is up, you can transfer funds electronically and invest in the index fund.

Bottomline

If you are looking to grow your money, but don’t have the time to do the necessary research, index funds are the way to go. You can also choose index ETFs because it also works pretty much the same way. Index funds are certainly a lot better than mutual funds, as index funds charge lower fees and over the long run, they generate better returns.

That being said, there is something I would like to bring your attention to.

As it turns out, most index fund investors seem to be individuals who’d rather invest in individual stocks but don’t have the time nor the resources to do so.

Well, the truth is, if you can spend just 20 mins a day, you can achieve market returns substantially higher than the market average – just by using what you already know. To know more, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.