By: Andrew Linderman

Blueleaf’s position: Index funds are a much better alternative than actively managed mutual funds for individual investors looking to have exposure to equities in their portfolios. Index funds have lower costs, lower volatility, and fewer capital gains tax expenses than actively managed funds.

Index funds are a special class of mutual funds that track the movement of a particular index, such as the S&P 500, Wilshire 5000, Russell 2000, or so on by holding all of the securities in the same proportions as their weight in the index. Unlike actively managed (“traditional”) mutual funds, index funds are passively managed and move with the market. As the index rises and falls, so too does the fund. This raises the question: how do index funds, which follow the market, achieve returns comparable to – and often better than –actively managed funds?

The answer is simple. Minimal (passive) management works in favor of investors by virtually eliminating transaction costs and drastically cutting operating expenses. [1] Passive fund management means that there is almost no trading of securities in the index, and subsequently very little fund turnover. This benefits investors in two ways. In the short run, fewer trades mean cost savings in the form of lower capital gains tax exposure. [2] Since no individual securities incur profits or losses—securities are traded only to follow the index— there is little to no tax impact on net returns. In the medium- and long-run, low fund turnover translates to a lower overall expense ratio. [3] A low expense ratio is especially beneficial for investors. Actively managed funds, which typically have a 100% annual turnover, typically have an expense ratio of 1-2% of fund assets. Index funds, by contrast, have expense ratios that are typically half that of actively managed funds. This may not seem significant, but consider this: a 1% difference in expenses compounded over a 20 year period translates to an 18% difference in returns. [4] What would you do with the extra money?

But are index funds riskier than actively managed funds?

Many investors assume that better returns translate to higher risk. [5] This is not the case with index funds. Index funds are inherently diverse since they include a large number of equities or bonds. Diversity in a portfolio protects investors from huge swings in the value of individual securities. Diversity also means that index investors don’t have to worry about the potentially disastrous decisions of overly aggressive or inattentive fund managers since nothing is actively traded.

Do index funds outperform actively managed funds?

Research shows that even the best actively managed funds struggle to outperform index funds. [6] An early study of index funds in the 1970s found that active funds, on average, underperform indexes by almost 85 basis points (0.85%). [7] Another study found that, among the 1,892 actively traded funds that existed between 1961 and 1993, these funds under-performed (compared to market indexes) by 1.8% per year, after adjusting for common factors in returns. [8]

Largely because of their low costs and low risk, index funds have been growing in popularity for the last few decades. In 1973, when index funds were relatively new, investors held just $50 million in index funds. By 1995, that number was roughly $1 trillion in US and foreign index funds. [9]

Even in the midst of an economic downturn, people are moving their money into index funds. Strategic Insight, a fund consultant, found that investors withdrew $200 billion from actively managed funds and put them into index funds in 2008. [10] This trend has led high profile investors to publicly endorse index funds. As Warren Buffet told CNBC anchor Liz Claman in 2007: “Buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry.” [11]

Index funds do have several limitations and may not be appropriate for all investors. Index funds follow the market, so they suffer alongside the economy in the short run. Highly skilled fund managers can often beat an index in the short run, as happened during the recent downturn. [12] In short, indexing is not the easiest way to make a quick buck.

Indexes are also not all equal. Some sector indexes, such as Vanguard’s Health Care, are subject to large changes due to government regulation. This vulnerability to large scale government action makes some sectors riskier than others. [13] In general, though, index funds are a safe and profitable hedge against high fund costs and market volatility.

[1] Larimore, Lindaur, and LeBoeuf. The Bogleheads’ Guide to Investing, John Wiley& Sons, Inc, 2006, pp79-80.

[2] Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 2007, p360-361

[3] Larimore, Lindaur, and LeBoeuf. The Bogleheads’ Guide to Investing, John Wiley& Sons, Inc, 2006, pp79-80.

[4] Ibid. The comparison of index and mutual fund returns assumes a $10,000 initial investment with an average annual return of 10% and an expense ratio of 1.5% (for the mutual fund) and .5% for the index.

[5] Lichtenstein, Kaufmann, and Bhagat. “Why Consumers Choose Managed Mutual Funds Over Index Funds: Hypotheses from Consumer Behavior.” The Journal of Consumer Affairs, Vol. 33, No. 1, 1999, p188.

[6] For an excellent overview of this topic, see Eugene Fama’s famous paper: “Efficient Capital Markets: A Review of Theory and Empirical Work.” The Journal of Finance, Vol. 25, No. 2, (May,1970), pp. 383-417.
[7] Rex Sinquefield’s opening statement in the 1995 debate at Schwabb “Active vs. Passive Management.”

[8] Ibid.

[9] Ibid.

[10] Frick, Robert. “Good News About Index Funds,” Kiplinger’s Personal Finance; Vol. 63 Issue 9, September 2009, p37-38. http://www.kiplinger.com/magazine/archives/2009/09/index-funds.html

[11] Spence, John. “Buffett gives nod to index funds over ETF’s”, Marketwatch, May 7, 2007. http://www.marketwatch.com/story/warren-buffett-backs-index-mutual-funds-over-etfs

[12] For more information, see Annelena Lobb’s article in the Wall Street Journal: “‘Active’ Did Better in ‘09”, The Wall Street Journal, January 10, 2010, Investing in Funds: A Quarterly Report, Q4. http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748703523504574604461064402716.html

[13] Larimore, Lindaur, and LeBoeuf. The Bogleheads’ Guide to Investing, John Wiley& Sons, Inc, 2006, pp 79-80.