The Advantages of Index Funds -- And Can You Get Even Better Returns from Them?

I like index funds and "collect" articles that talk about how they can earn investors lots of money. Here's one to add to the list. It's from USA Today and gives some thoughts on why index funds are such great investments:

Index funds simply track a market index, such as the Standard & Poor's 500 (SPX). The advantage is clear: The average managed stock fund rarely beats a broad-based market index, such as the Standard & Poor's 500, over long periods.

There are two main reasons. For one thing, index funds don't need a manager or troops of analysts, so they cost much less to run than actively managed funds do. Low costs are a tremendous advantage. An average stock fund will match the market's average returns over time, minus expenses. And an index fund that charges 0.2% a year will usually beat the average stock fund, which charges 1.5% a year.

The second reason: Efficient market theory holds that stock prices generally reflect all that's known about a company. If that's true, you're better off buying a fund that tracks the entire market, rather than one that tries to find, say, undiscovered growth stocks.

Yep. That's why I love index funds.

But wait, there may be a spin on index funds that performs even better:

A dividend-weighted index has outperformed the S&P 500 over the past 10 years by about 2 percentage points a year. The index has a higher dividend yield than the S&P 500, as well as a slightly lower price-earnings ratio, both of which appeal to value investors.

But is this really index investing? Not according to Vanguard:

Gus Sauter, chief investment officer at the Vanguard Group, says a dividend-weighted index is tantamount to active investing, not indexing.

Here's USA Today's bottom line:

If your main goal is to achieve broad exposure to the stock market at very low cost, then owning a few index funds is an excellent strategy. The Vanguard Total Stock Market Index fund (VTI), for example, would give you good exposure to virtually all U.S. stocks at very low cost. If you want even more diversification — with a value or small-cap tilt — these new types of index funds might not be a bad idea.

I can agree with this. While I have a good amount in index funds, I also invest in other mutual funds, a handful of stocks, and some real estate. In other words, I don't put all my financial eggs in the index fund basket. In the long run, that strategy has worked well for me -- though I could tell you some stories of my early days in stock investing that weren't pretty at all. ;-)

Comments

[William Tanksley]

I'm not sure I agree with the Vanguard person quoted there (although I am a fan of index investing). The problem is that there's no real definition of what an "index" is. What's the difference between the Dow and some arbitrary approach like selecting the highest dividend payers (assuming you're careful to choose a stable criterion)? It seems to me that neither one is an index fund, but both are perfectly legit investments that can give most of the benefits of index investing. I think a good name for this type of investing would be "automated investing" -- pick a stable criteria, and just follow it blindly. This is exactly what the Dow and the S&P500 do, but there's no reason why we should assume that their criteria are the best.

[douglas]

i just invested 100,000 in a managed fund. only returning 6%. but fees are 2.49% crazy to pay the fees. i learned my lesson. the money will be pulled by next week and put into index funds. big mistake, i thought i could trust my finance guy, but he is the one laughing the whole way to the bank.