In Warren Buffet’s 1996 annual letter to shareholders, he proclaimed:

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

So, great returns and low costs, but what are index funds?

What are Index Funds?

Index funds are designed to track stock indices such as the S&P 500. Indexing is passive investing, instead of having a manager select stocks and the asset allocation in a portfolio, you mostly buy them for buy and hold strategies. Oftentimes index funds will have expense ratios of < 1% with many sub-0.5%. They trade the same way as mutual funds where inflows or outflows will occur after the market has closed, at the closing price for that day.

There are many types of index funds from funds that track the S&P 500 to funds that track various real estate indices. Bloomberg has a comprehensive list of all index funds.

Index funds were first introduced into the market in 1975 by John Bogle, the founder of Vanguard. Since then, their usage has grown substantially to the point that in 2007, Index Funds comprised 11% of all equity mutual funds.

Why Index Funds?

Out of over 4,000 active funds that invest in large U.S. stocks, only 17% of them beat their benchmark. In fact, in most years, fewer than half beat their targets (WSJ). That’s staggering. If funds managed by professionals can’t even beat the market, how are main street investors supposed to?

Index funds are a cheap alternative to actively traded funds and have better results. They allow investors with limited market knowledge to be broadly diversified while not having their portfolio values be eroded by fees.

The Importance of Low Fees

Here’s an example of how high-fee mutual funds can erode your gains:

Mutual Fund Index Fund
ROR 7% 7%
Expense Ratio 2% 0.5%
Starting Sum $50,000 $50,000
Total Expenses  $123,425.60  $46,582.04
Final Market Value After 40 Years  $327,031.97  $609,631.53

 

By choosing the index fund over the mutual fund you’d be left with nearly twice as much money.

Index Fund vs. Mutual Fund Performance

Index Fund vs. Mutual Fund Expenses

View the full analysis here.

Additional Resources:

Vanguard Expense Tool: https://personal.vanguard.com/us/insights/investingtruths/investing-truth-about-cost

All About Mutual Funds: http://www.iwillteachyoutoberich.com/blog/all-about-mutual-funds/

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About Bobby Kania

Bobby Kania graduated Summa Cum Laude from Virginia Tech with a B.S. in Computer Science, and minors in Music and Math. During his summers as an undergraduate, Bobby interned with Bloomberg, L.P. and General Electric. He was also the Treasuries Sector Head in Bond And Securities Investing by Students (BASIS). He currently works as an analyst for a major bank.

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