All About Index Funds

What is indexing?
Indexing is an investment strategy to match (replicate) the performance of a chosen stock or bond market index. Indexing is often referred to as a passive investment approach, as the unit trust seeks to just track 100% of the movement of the selected index. Usually this is accomplished by buying a small amount of each stock in a market. An index, such as the S&P 500 or MSCI, is the number that represents the market or group of stocks

What percentage of mutual funds are beaten by index funds?
Over the long-term the S&P 500 index has beaten about 65-80% of mutual funds (unit trusts), depending on the time period. This is especially true when one takes into account “survivorship” bias. This bias occurs because the worst performing funds typically go out of business and are not counted in long-term records. Thus long-term performance of surviving funds tends to be higher than the sum of annual performances. Many fund groups “seed” numerous funds with small amounts of money precisely in order to weed out poor performers and to promote the “star” funds.

How do index funds offer lower risk with diversification?
Indexing guarantees that an investor’s money will be spread over the entire market. Mutual funds or individual investors who pick stocks generally restrict themselves to a limited number of stocks so they can devote sufficient time to each.

Why index?
Numerous independent studies have shown that indexing provides greater returns over time with less risk and lower taxes. In any given year most active funds (non-index funds) under perform markets they set out to beat, especially after fees are subtracted. Indexing provides the most broadly diversified equity and bond unit trust products available to investors.

Beating the market over the long-term is a loser’s game. Here’s why:

  • Investing Is a Zero-Sum Game. Investors as a whole make up the market, so as a group, investors can do no better than the market itself. If one investor outperforms the market, another must underperform it by a like amount.
  • Mutual Fund Costs Diminish Returns. If funds had no costs, investors as a whole would match the market’s returns (as measured by a benchmark index). But after costs (sales loads, operating expenses, and so on), investors do less well than the index, because the index doesn’t have costs.
  • Financial Markets Are Efficient. Information is so readily available, especially about large U.S. companies, that it’s tough for any fund manager to sustain a performance edge over the long-term. Some markets are less efficient (for example, international and U.S. small-capitalization markets), but they tend to have higher costs, which erode their returns.

Of course, some actively managed funds do beat the market over many years. But those cases are exceptional. More often, today’s top-performing funds become tomorrow’s average performers. And over time, the average index fund has tended to outperform the majority of actively managed funds in its category.

What is an index fund?
An index fund is a unit trust that mirrors as closely as possible the performance of a stock market or bond index. For example, many mutual fund companies have since established S&P 500 index funds to mirror that index by purchasing all 500 stocks in the same percentages as the index.

How do index funds differ from other unit trusts (mutual funds)?
Unlike conventional investing strategies, indexing is designed to track, rather than beat the market performance.
Generally, the securities in an index fund are not actively traded, except when changes in their market valuation make it necessary to adjust the fund’s holdings to keep it in line with its benchmark. 1) Index funds track markets closely instead of trying to outperform them.
2) Index funds tend to be much cheaper since there are no highly paid managers to pick stocks.
3) Index funds delay capital gains taxes because stock turnover (buying and selling) is low.

How does indexing work?
For the average investor, indexing involves:
1) Picking indexes that provide the right mix of return and risk for their situation.
2) Picking funds that follow those indexes.

What can an index fund track?
Index funds exist for a broad range of asset classes, including short, intermediate, and long-term bonds; U.S. large and small company stocks; value (low price relative to earnings) and growth (high price relative to earnings) stocks; international large and small company stocks; emerging market stocks, and others. In practice, most index investing involves common stocks and a majority of that centers around the S&P 500 Index and MSCI International indices.

How do index funds provide higher average returns?
Lower management fees make this a near mathematical certainty that a fund tracking an index will outperform actively managed (stock picking) investors seeking to beat that index.

How do index funds offer less worry?
Since operating an index mutual fund involves no decision making, there is little for an investor to supervise. Indexing eliminates the risks, costs, and uncertainties of “active” management (stock picking and market timing). Index investors tend to sleep easier at night.


Index Funds - Did You Know

Index funds outperform more than 80% of active fund managers over 3 - 15 years.


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