The very first index fund was created on December 31 of 1975 by Vanguard, the company founded by legendary investor John Bogle. Bogle’s philosophy is to provide low cost, well-diversified investments to retail investors at a low cost.
Index funds currently have over $4 trillion in assets, as investors are favoring a passive approach in today’s stock markets. In fact, index funds are now one of the main buyers of equities globally.
Here is a chart of the growth of index funds since their inception in 1975:
Let’s take a deep dive and talk index funds, and compare them to actively managed vehicles.
What are index funds?
An index fund is sold as a share or unit, which gives you fractional ownership of a basket of securities. These funds have the sole purpose of replicating the performance of a target asset.
For example, your goal is to buy the entire stock market at once, without having to pick individual stocks.
You prefer to own the largest companies in the US stock market. The S&P 500 stock market index would be your preferred asset in this case. You would then look to buy an S&P 500 index fund.
The entire goal of the index fund is to track the S&P 500 stock market index. Fund managers who receive your money will aim to only replicate the index, and not beat it.
So if the S&P500 earns a 10% return in a single year, the goal for the index fund would be to earn the same amount. There is no pressure to “beat the market”.
For the fund manager, the job is fairly easy. They invest the pool of investor assets in equal proportion to what the index holds. Assets are balanced regularly to ensure they mirror the asset they are tracking.
But what if you want to buy an index fund that tracks only the technology sector in the stock market?
You can do that by purchasing a Nasdaq index fund, which will split the money equally across all the stocks in the Nasdaq.
The main benefit, therefore, is that you do not have to worry about picking the best stocks. Stock picking can take hundreds of hours of reading shareholder reports, financial statements, and management research. Most actively managed funds do all this work and still under-perform in comparison to index funds. We will look at this in a future part of the article.
At this point, all you need to know is that an index fund gives you access to all the stock companies in an index without having to buy each individually. This is a massive benefit for many reasons which we will explore.
Mutual funds versus ETF index funds
Before we proceed further with index funds, it is important for you to also understand what mutual funds are.
These investments are historically an active portfolio management service. Big banks sell these investments to their clients, with the promise of beating the stock market.
Mutual funds promise to earn a bigger return than index funds, and for this reason, they charge you more on an annual basis.
Because these portfolios are actively managed, there is a higher cost. Managers need to research companies, build and maintain investment models, and constantly fight to maintain an edge that is scalable to multiple billions. This is not easy.
In fact, most mutual funds and actively managed portfolios underperform the passive index fund approach.
Lately, mutual funds have started to offer more passive portfolio solutions to clients because they have been losing business to index funds.
Let’s jump into the big benefits of these index funds.
Index fund diversification
One massive advantage is that you can own a basket of stocks at once without needing massive capital.
To illustrate this advantage more clearly, it would cost you over $56,000 US to buy one share of all the 500 companies in the index. The SPY index fund (symbol: SPY) costs just $264.74 per “share” today. This means for less than $300 USD, you can follow the entire S&P 500 index.
Once you purchase index fund shares, your investment will increase at approximately the same rate as the index it tracks.
You can own an entire index in any stock market in the world.
From emerging market countries to Asian, Latin American or even the entire world index. Whatever asset class you can think of, there is an index fund for it.
In addition, you can own multiple asset classes in one index fund. You can get the growth of the stock market, while also getting the income benefits of a bond portfolio. An equal allocation into both would create what is called a “balanced portfolio”.
The investment possibilities with index funds are endless, which is why they have grown in popularity.
Towards the end of this article, I will include a list of the largest index funds in the world.
Index fund expense ratios (cost)
Index funds are cheaper to run than actively managed funds, but they are not free.
Fund managers need to purchase and sell stock to maintain the tracking and mirroring of the desired investment classes. In addition, they have to pay administrative costs including staff and overhead costs like any other business.
The cost savings occur because they do not have to make massive payments to the fund managers. Active funds usually charge 2% a year administration fees, regardless of their performance.
Most index funds charge less than half a percent. SPY charges just 0.10% annually, a massive difference when compared to active funds.
How much of a difference does cost make?
Vanguard did a study, which assumed you invested $100,000 USD for 25 years at a 6% annual rate of return.
How much of a difference do you expect? How much potential profit is eaten up with the higher cost of actively managed funds?
Assuming both funds returned 6% a year, the actively managed fund would need to earn an additional $170,000 in returns to pay for the cost of active management. Wow!
After 25 years, your portfolio will be worth $430,000 USD with low cost index funds, versus just $260,000 with the high costs of active funds. Of course, this assumes active funds cannot beat the market – which is an accurate assumption for over 90% of existing funds. It is very rare to find a fund that consistently beats the market in the long run.
Overall, index funds mean that you get to keep more of the investment returns, and way less in fees.
As an investor, you need to keep as much of the profit as possible, simply because you assumed the entire risk.
So how can you incorporate index funds in your investment portfolio?
There are many ways, and the good news is that you do not need to choose.
How to invest and trade index funds
There are two options when it comes time to taking advantage of index funds, and it all depends on your unique goals. Active and passive investment strategies are the two.
You do not have to choose one over the other. It makes sense to start with one as a beginner, but eventually, you will need to know both to grow your nest egg.
Passive Investing with Index Funds
If you prefer to invest passively in the stock market, you can just buy an index fund and hold it until retirement.
Just remember, your portfolio will be prone to market swings and fluctuations to the same extent as they occur in the stock market index.
This is the Warren Buffet, buy and hold forever strategy. It takes the least time and effort, and you can even purchase regularly to take advantage of the power of dollar cost averaging (DCA). This is a topic for an entirely different article, however.
Active Trading with Index Funds
Index funds can be very useful, as they allow you to time the market using technical analysis to increase your profit. The idea is to sell in extreme bull markets to lock your profit and get back in when markets drop.
Timing the market is something that requires a great degree of skill. You will need to invest time into learning how to time the market properly. A lot of practice is involved, but there are very specific rules that can help you allocate your capital tactfully.
If you follow the business and economic cycles, strategic sector rotation can yield some amazing results.
The most important part is to have an active trading strategy and to be a part of a community of professional traders from whom you can learn.
This is our skill set, and our community of professional traders is earning full time income daily.
All you have to do is join, and start learning about how to manage your portfolio actively.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.