Why You’re Better Off Investing in Index Funds

Investors often opt for actively managed mutual funds or ETF’s as a way to “beat the market”. Occasionally, over short spells, they may in fact beat the market. But these forays into managed funds can also increase risk. That then begs the questions: should you invest in actively managed funds and attempt to get higher returns? Or should you stay with index funds and be content to reliably track the market?

Few Actively Managed Funds Beat the Market Consistently

It’s close to a myth that actively managed funds outperform index funds. According to a recent study, index funds outperform managed funds as much as 90% of the time.

A complication — or perhaps a distortion — occurs because there are times when an actively managed fund can outperform the market, at least for short periods of time. However, reality and statistics clearly show that very few actively managed funds will outperform index funds for more than one or two years.

The higher performance could also be a result of a fund that holds large positions in a small number of companies that are performing at well above market averages. But once the growth curve on the high-flyers slows, performance of the fund is back to normal, and may even begin underperforming index funds.

There is Nothing Worse than Underperforming the Market

There is a flip-side with actively managed funds that most investors don’t give much thought to, at least not when they are buying in. Everyone buys into a fund under the optimistic assumption that it will outperform market — if they didn’t, there would be no point investing in the fund at all.

It’s fine if the fund at least keeps pace with the market, and especially if it outperforms it, but what happens if the actively managed fund begins to under-perform the market?

There is probably no single factor that so upsets an investor as holding an investment that is underperforming the market. Index funds will always perform consistently with the market; but an actively managed fund has the very real potential to under-perform it.

How would you feel paying a professional fund manager to under-perform the market? That is a very likely outcome if you are investing in actively managed fund.

It Removes the Need to Select Funds

One of the very best reasons to invest in index funds is that you can choose your investments and forget about them. This is as it should be, after all you have your life to live and a job to do that probably has nothing to do with the stock market. Index funds make it easier for you to tend to your business, rather than worrying about what you have your money invested in.

If you choose to go to actively managed funds, you’re going to have to do a substantial amount of research. This will go beyond simply looking at the fund’s performance the past few years. You’ll have to be concerned with the fund managers investment philosophies and whether or not they match your own.

You’ll also have to be concerned with holding positions in funds that may be at least somewhat out of sync with the general market. If the fund is invested heavily in positions that are counter to the general market, you have to be comfortable with the potential for those investments to go in the wrong direction.

If you invest primarily or entirely in index funds, none of that will be a concern.

Lower Investment Fees

Actively managed funds incur significant transaction fees due precisely to the increased activity. This is especially true if the fund is a high turnover fund, which means that there is a portfolio turnover rate in stock holdings that exceeds 100% per year.

Index funds on the other hand tend to be fairly static when it comes to turnover. A change in portfolio holdings will generally only occur if there is a change in the securities represented in the index that the fund is tracking. For example, if you’re investing in an index fund that is tied to the Dow Jones Industrial Average, stock turnover will mostly occur when the Dow removes one or more companies from the average, and adds others to replace it.

On an annual basis, the additional fees from actively managed funds might amount to no more than 1%. That may seem as if it isn’t much, but it could reduce the average annual return on your investment from say 10% to just 9% — remember, there’s no evidence that actively managed funds outperform index funds to make up for the higher fees.

Over time, that 1% difference in investment return could add up to something substantial. $100,000 invested at 10% for 30 years will result in a $1,744,940 portfolio. The same amount invested for 30 years at 9% will result in a $1,326,768 balance.. That’s a difference of well over $400,000 over 30 years – just from a 1% difference in investment fees!

For most people, index funds will be the best way to invest in the stock market, at least with the majority of their portfolios. While your 401k or 403b may not offer index funds, some employer plans include them and you can certainly invest in index funds if you manage your own Roth IRA, IRA, or personal/brokerage account.

What do you think of index funds? Are they the best funds for most investors? Feel free to disagree!

About the Author

By , on Feb 22, 2013
Kevin Mercadante is a professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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  1. From what I’ve read, index funds do seem to make the most sense for me. I haven’t started my retirement fund yet (I’m 23, will start once I pay off my debt this year), when I do, I think index funds will play a role. I’d rather be average all of the time than above average sometimes and below average sometimes.

    • Kevin says:

      Hi Jordann–And you’d rather be no worse than average if the market falls. A lot of the actively managed funds that occasionally beat the market, take even bigger hits when the market drops. None of us want to be a part of that!

  2. Love my Vanguard TSMI fund. Thanks for confirming my beliefs in this post!

  3. Thad says:

    The problem with index funds is they don’t seem “sexy”. That they are consistent in their returns gets lost among the marketing.

    • Kevin says:

      Hi Thad–That is an excellent, excellent(!) point. Beat-the-market strategies ARE sexy, and get the attention. Even if they don’t actually beat the market on a long term basis, the promise is powerful.

  4. It is true that most actively managed funds do not beat the market and that my friend is why I do not invest in mutual funds.

  5. Excellent points! Index funds are easy to understand and provide the beginner a great way to get started with their investing career.

  6. Alex says:

    I think index funds are the friends of many investors because they take out the work and they take out the emotion. Both of those things get in the way of me personally being a good investor.

  7. Pauline says:

    I am certainly not smarter than the market nor do I want to take the time to try to be. I have only invested in index so far, some riskier than other but the risk is always spread between many companies.

    • Kevin says:

      Hi Pauline–That’s one of the biggest factors too–you have other things to do in your life, and index funds free you up to tend to them. The only thing you have to do is decide when and how much to invest.

  8. I think index funds are the way to go for the majority of people. Often the best thing we can do for our overall returns is to keep our commissions and maitenence fees as low as possible. Index funds are one of the best ways to accomplish that.

  9. My big problem has been that etrade has plenty of mutual funds available for no transaction fee, but all of the index funds do. When you have such small amounts to invest as I do, $35/trade eats up a lot of my money.

  10. Index funds are the best! The market has averaged a 10% return over its lifetime, so why mess with anything esle?

  11. krantcents says:

    Investments are for the long term, yet we do not think about the expense factor. If you are investing for 30-40 years those expenses add up.

    • Kevin says:

      That’s an excellent point about investment expenses over several decades. They really add up and take a huge bite out of your portfolio in that space of time.

  12. Jose says:

    Most of the funds I’m in are targeted at very specific areas such as precious metals, Asia-Pac, Latin America etc. BUT, I’ve done a lot of homework to select those funds. I’m happy with their overall performance. Do they beat the market? Pick a time frame and range and the answer will vary. That’s one of the problems with trying to gauge whether a fund beats the market or not. It can vary depending on the time frame your looking at. I think the best way to look at it is over a long stretch of time. Most of the funds I’m in are very aggressive and when they lose, they lose big but when their up they’re up big as well. One example of this is a precious metals fund that I used to like a lot but have waned on over the last few years. SCGDX. It’s 10 year annualized rate of return is 11.32% if you compare this to the Dow at 8.31% and the S&P 500 at 7.93% over the last 10 years, It is definitely beating the markets over the long term. But, if you look at it over a shorter term, 1 year for example, it had a loss of 23.15%, which is pretty ugly. I would say that one major factor you should consider when deciding on Index vs target funds is how long you plan to stay invested (as well as your tolerance for risk).

    • Kevin says:

      Hi Jose–It may be that in general you’re best to stay in index funds, but step out to take advantage of manias as they develop. It isn’t always either/or–sometimes the answer is “both”.

  13. Debt RoundUp says:

    I have a few index funds, but that is because I am a beginner and don’t have a lot of time to dedicate. I plan on moving to some other more active investments once I get some knowledge under my belt.

    • Kevin says:

      You’re going about it in the right way. You can gradually ease into more agressive positions as your skill and confidence grow. And it’s not an either/or situation either. You can do both forever if that’s what you choose to do.

  14. Good post Kevin! I think that index funds are great for beginners as well as for those who do not have the time to actively manage a portfolio of stocks/bonds. I’d much rather keep pace with the market as opposed to paying higher fees or take losses on a specific stock.

  15. Savvy Scot says:

    I think index funds are great for beginner investors, but when you get a bit more experience, or have a longer end game in mind – Funds / Stocks should be bought! 🙂

    • Kevin says:

      With the caveat that you develop the necessary investor skills. If not, you could lose a lot of money. I’m also no so sure that a society weened on instant gratification has the patience to go that route.

  16. I prefer to select my own stocks that have a history of dividend growth, wide moats, and appear to be undervalued. I have actually compared my strategy to what would have happened if I just purchased an S&P500 ETF. As of the end of 2012, I am beating the S&P500 in terms of both capital gains and dividends.

    I agree that index funds are better than actively managed funds, but I think that value investing has the possibility of beating both, or at a minimum matching the market.

    • Kevin says:

      I agree with you on value stocks, but most people don’t have the knowledge or the inclination to do the research and make the critical decisions. For most people, index funds are the way to go. Equity participation without the investment of time.

      • I agree with Kevin on this. I am currently at Columbia Business to learn more about Value Investing from the guys who have literally written the books on Value Investing. It takes time, lots of research, careful analysis, and lets be honest, still a bit of luck.

        More importantly there is the emotional aspect of investing that many just can’t deal with, such as pull out of investments as they go down instead of averaging down to get a better average entry price.

        You also need to think about how much money you can devote to straight stocks. If it isn’t enough to own a diversified portfolio of stocks, that increases your risk.

        I think you have to do a gut check with yourself as an investor and see what type of investor you are. Not willing to put in the time? Get emotional at downturns? Can’t put in the bank roll? I think Index might be the way to go…

        • Kevin says:

          Hi Lacy–You’re so right, most people don’t have the emotional fortitude to ride the ups and downs of the market. You have that with index funds but it’s not as extreme as it typically is with managed funds or individual stocks.

          In addition, people get bold during “elevator rise” phases such as we’ve been seeing for the past 4 years. But when the markets get ugly, panic takes over. What has been working since the spring of 2009 isn’t typical of the stock market. Unless you can ride out the downturns, you probably need to stay with index funds.

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