Mutual funds can be called lots of negative things — expensive, underperforming, inconsistent.
That’s the label some critics attach to a type of mutual fund called index funds, which since their inception in the 1970s have boomed in popularity — essentially by doing as little as possible.
“Some people think index funds are un-American because the stocks in the fund are there based solely on inclusion in an index,” said Michael Rawson, manager research analyst at Morningstar.com. “They think you should have to do your homework when deciding where it’s best to put your money.”
Political views aside, index funds can be a smart choice for solid performance and low cost to the investor. But anyone hoping for returns that beat the market averages or who like to brag about profiting off the hottest stock pick of the day may want to look elsewhere.
Index funds defined
Index funds are mutual funds constructed to match or track the components of a market index. These can include such well-known groups as the Standard & Poor's 500 Index, the Russell 2000 (which encompasses small companies) and the DJ Wilshire 5000, the total stock market index.
Index funds are a form of passive investing. Rather than trying to buy and sell stocks with the best growth potential, reliable dividend payments or other parameters, index funds simply mimic the holdings of a particular index. When an index drops a company or adds a new one, so does a corresponding index fund.
Many index funds also function in lockstep with what’s known as market capitalization (a term that refers to the dollar value of a company’s shares). A company that’s worth more than other companies in an index will represent a larger ownership share in the corresponding index fund. Other funds use an “equal weight” approach in which all stocks in an index are owned equally.
Index fund advantages
Since arriving on the market some 40 years ago, 372 index funds had a total of $1.7 trillion under management, according to the 2014 Investment Company Fact Book. Looked at another way, roughly one-third of all households that invested in mutual funds owned at least one index fund.
One longstanding appeal of index funds is performance — returns that usually beat those of more actively managed funds. While the stock market as a whole has continued to prosper, many actively managed funds have failed to keep pace.
For example, the Vanguard 500 Index Fund Investor Shares (VFINX) has outperformed nearly three-quarters of actively managed large blend funds during the past 10 years, returning 8.2 percent per year compared to an average of 7.4 percent for other large blend funds, according to Morningstar. (Blend funds invest in a wide variety of stocks, including large and small companies.)
One reason for index funds’ success is broad market exposure, offering investors diversity and holdings in a large number of stocks.
“Broad-based index funds like the S&P 500 or Russell 2000 are well-defined so you can build a portfolio to get the overall exposure you are looking for,” said Mark Wilson, chief investment officer of the Tarbox Group in Newport Beach, California.
Low cost is another major advantage that contributes to solid performance. Because index funds require less oversight than other mutual funds comprised of certain selected stocks, the management fees are low, which means investors keep a larger share of an index fund's gains.
As Morningstar’s Rawson pointed out, the average expense ratio of all mutual funds is roughly 1.2 percent compared to the index funds average of .70 percent, with some as low as 0.10 percent (that’s a charge of $10 for every $10,000 invested, versus $120 for the average mutual fund.)
“I’m a firm believer that the lower you keep your costs, the higher your probability of success,” said Andrew Feldman of AJ Feldman Financial in Chicago. “The simple logic is that, if you keep more of your money, you have more to invest and grow upon itself.”
Proponents also argue that index funds eliminate the challenge of finding a mutual fund manager with the chops to beat the averages — a challenge that statistics suggest is difficult to overcome.
“Finding these winners ahead of time is very difficult — or impossible,” said Wilson. “If an index fund will outperform 80 percent of its category peers over most five to 10-year periods, why wouldn’t I choose that as a core holding?”
Despite many attributes, critics are quick to point out flaws in index funds, starting with their makeup, which some allege isn’t a bona fide investment strategy.
“The well-known Standard & Poors 500 is not comprised of the 500 largest companies in the country but the 500 companies of most interest to investors,” said Columbus, Indiana, Certified Financial Planner Warren Ward. “I continue to believe that if decisions about selecting stocks or bonds are to be made, they should be made by professional investment managers, not editors.”
The function of index funds to be fully invested can also be of concern in a market that’s trending down.
“If a market turns negative, active funds can sell off some holdings and go to cash,” said Rawson. “Index funds are always fully invested.”
Investors should also be aware of needless trading activity between funds. As Wayzata, Minnesota, Certified Financial Planner Rick Epple explained, a stock that’s removed from one index and lands in another can be sold and then bought again by a fund tracking both indexes — impacting both operating expenses and overall return.
Index funds’ popularity attest to their appeal for all sorts of investors — particularly those without the time or the motivation to do the necessary legwork to find attractive alternatives.
“If you’re not willing to do enough research into a fund’s management or performance, index funds are certainly a good choice,” said Rawson.
Given that index funds generally have little buying or selling, tax efficiency is yet another advantage (any sort of fund activity can result in tax consequences.) That can make index funds particularly suited to taxable accounts, as opposed to individual retirement accounts, 401(k)s and other vehicles that defer taxes.
On a somewhat less financial note, index funds can also suit investors who don’t care about the warrior mentality that can come with investing — the thrill of scouring the landscape to pick out a winner.
“Investors love when they can pick a stock like Apple and tell all of their friends how smart they are,” said Feldman. “While you may not be able to brag about owning the hottest stock while you are golfing with your friends, you may be golfing earlier in retirement if you keep up with that sort of prudent investment strategy.”