Summary/TL;DR
An index fund is a fund which tracks the performance of an index. Today, index funds exist for just about any asset class or combination of asset classes that you can imagine. Because the criteria used to construct an index fund is objective and simple, they have produced remarkably consistent returns over time and are extremely cost efficient. In fact, passive index funds have outperformed about 95% of professional fund managers.
Given the historically superior performance and lower cost offered by index funds, it is no surprise that they have disrupted the landscape of portfolio management services. Now that a reliable, safe, and cost-effective investment vehicle has entered the field, more and more financial advisors are having trouble justifying their 1.00% (or higher) asset management fees.
What is Index Fund
An index is a standardized way to track the performance of a group of assets, such as stocks, bonds, or other “securities”. An index fund, then, is a fund, available for purchase, which tracks the performance of a group of assets (an index).
The S&P 500 or Dow Jones Industrial Average are the most well recognized stock indexes in the world. It is in reference to these indexes that media pundits, politicians, and advisors alike speak of “the market”. There are also indexes for bonds, international stocks, stock options, different sectors and subsectors of the market (like energy, technology, or retail banking), aggressive portfolios, conservative portfolios… if you can name it, there’s probably an index for it.
How Indexes Are Constructed
For the sake of this post, I will refer almost exclusively to the S&P 500 index. The S&P 500 is an index which tracks the 500 largest publicly traded companies in the United States based on market capitalization (the total value of a company’s outstanding shares).
But what determines the weight of each stock in the index? What criteria determine which stocks make up a larger piece of the “index-pie”? There are lots of different ways to make this decision. Some indexes will weigh companies based on price (such as the Dow), others will weigh them equally, and still others will weigh them based on market capitalization (such as the S&P).
For example, Apple, being the largest company in the United States, is given the largest weight in the S&P 500. In fact, the 10 largest companies alone account for over 30% of the index’s weight at the time of this writing. Taken together, this means that the movement of these company’s stocks has far more of an impact on the index than their smaller counterparts. And as companies become larger/smaller, so does their representation in the index. By design, companies which are failing in the marketplace (and are therefore falling in value) will generally be replaced by companies which are faring better, while companies which are doing exceptionally well will be given more and more weight over time.
The Strengths of Index Funds
Superior Construction Criteria
Let’s pause for a moment and think about the implications of structuring an index this way. For the most part, a company will not be considered one of the 500 “largest” companies in the United States unless it has seen a great deal of success. That is, it’s highly profitable, has grown a great deal over the course of its existence, and, consequently, is led by some of the brightest and most innovative minds in the country (which also happens to be the wealthiest country in the world). And adaptability is an organic feature of the index; the moment that a company ceases to become one of the largest, most profitable, most successful companies in the United States, it gets replaced by another which fits the bill.
Hopefully this makes it clear why index fund investing has proven to be so successful over the years – it prevents an overconcentration of highly speculative or unprofitable stocks in one’s portfolio. In fact, it all but guarantees a curated collection of high-performing, innovative companies.
Think about it this way: if you set out to research the collective valuation of the 500 most successful publicly traded companies in the wealthiest country in the world over time, what would you expect to find? Of course, we wouldn’t expect the index value to consistently increase every day, week, month, or even year. But what about over long stretches of time? Is there any other reasonable answer besides “consistent increases in value”? If you’re visualizing something like what you see in the chart below, which is the value of the S&P 500 index since 1926 (provided by Macrotrends), then I think you’ve got it!
Inherent Safety
Furthermore, index fund investing is far safer than investing in individual stocks. This is because there will always be 500 companies which will comprise the index. This is not to say that index funds don’t carry risks – they certainly do – but the days of one’s portfolio going bust and “never coming back” are essentially gone (barring all-out Armageddon, that is).
The Consistency of Index Funds
Multiple lines of research spanning a multitude of methodologies, data sets, and time horizons have shown the persistent upward trend of stock prices over long stretches of time. A bonus chart is included below from Jeremy Siegel’s Stocks for the Long Run, arguably the most important stock investing book of all time. This shows the long-term inflation-adjusted return for all asset classes since 1801! Unsurprisingly, the stock index sticks out and looks precisely how we’d expect given the discussion above.
It’s no wonder that Warren Buffet, arguably the greatest investor who’s ever lived, has instructed the trustee of his estate to put 90% of the funds into low-fee stock index funds, with the remainder going into short-term government bonds!
Superior Performance. Lower Fees. Win-Win.
Another compelling feature of index funds is their track record compared to professional asset managers. Consider the following: 95% of professional asset managers underperform their benchmarks (indexes) over a 20-year period.
These asset managers will often charge portfolio management fees of 1.00% (or higher!), and most consumers have no idea what the true cost of that fee is. Consider the following: an investor starting with $1,000,000 and charged 1.00% for 20 years will have a portfolio almost $700,000 smaller than one that invested in index funds and was charged little to no fees (assuming the investments in both portfolios increased an average of 7.00% annually). This equates to about 25% of the portfolio’s earnings over that period – gone!
Index funds, however, are extremely cheap, with expense ratios usually no higher than 0.10%. There are even some index funds which are completely free to invest in! Index funds have completely transformed the portfolio management landscape, as it is now easier than ever to invest one’s portfolio in reliable, safe, cost-effective vehicles.
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