Why Invest in an Index?

Why invest in an index? The answer to this is simple: You are more likely to come out ahead in the long run. I’m sure your thinking about that magazine which touted a fund with excellent returns. The ad probably ran something like, “Fund XXX beat the market by 5% for 5 years running!” Great, it has done well in the past but what we really want to know is the future. Unfortunately, we can not predict the future but we do know some facts:

• Actively managed funds tend to be expensive.
• Actively managed funds tend to trade a lot.
• You can name the mutual funds that have beaten the market, on average, for greater than 10 years on one hand.
• For every fund that you can name, that beat the market, there are hundreds that did not.

What does this tell us?

If you pick an actively managed fund it has to overcome its expense ratio. That means if the fund has an expense ratio of 1.5% it has to do 1.5% better than its respective index just to meet the index returns. Just obtaining this feat is astounding in its own right. Score one for why you should invest in an index!

The actively managed fund is likely to have a high turnover. What this means is its going to trade a lot in order to attempt to beat the index. Unfortunately for the investor, you, this means more taxes. While the active fund is actively trading our index fund isn’t buying or selling anything unless the index it tracks changes. Active funds tend to generate lots of capital gains while index funds capital gains are generally very small. Score two for why you should invest in an index! (Unless you enjoy paying more taxes)

The fact is that not many funds exists which have beaten an index fund over the years. Everyone tends to remember the Fidelity Magellan fund which did well for a very long time. Time ended up catching up with it though and it hasn’t faired so well. Warren Buffet is another name that comes to mind when thinking of people that have beaten the market. Warren Buffet is a defiant oddity in the investing world as his returns have rained supreme for many decades. Can you name another that has done so well? I can not.

Now I ask one final question: Whom would you have picked to manage your money back in the past: Warren Buffet or perhaps one of the thousands of other now extinct mutual funds? Hopefully for your own sake I have convinced you that investing in an index fund is the most likely way to succeed.