More Reasons to Invest in Index Funds

Vanguard recently ran this piece that celebrated the 30-year anniversary of the first index fund. A key part of the article asked, "Why use indexing?" Here's what Vanguard had to say:

One economics professor had an answer to that question. When Princeton Professor Burton G. Malkiel wrote A Random Walk Down Wall Street in 1973, he explained in plain English why it's so difficult to outperform market averages, which are unburdened by investment management costs. Simply tracking an index's performance, he said, offered a superior long-term strategy.

A Random Walk, which went on to become a mainstay in personal finance publishing, proved to be prescient. By simply buying and holding the stocks listed in the Standard & Poor's 500 Index, the new Vanguard fund automatically maintained a diversified portfolio with low turnover, which in turn minimized costs and capital gains distributions. The numbers added up to sustainable advantages over higher-cost, actively managed funds.

Yep. These are some of the reasons I like index funds. Low costs and minimized capital gains make it hard for other investment alternatives to beat index funds.

The piece ended with a few stats on Vanguard index funds in particular (the index funds I primarily invest in):

• 71% of Vanguard index funds outperformed their respective peer-group averages over the ten years ended March 31, 2006.

• When Vanguard 500 Index Fund began operations in 1976, it was one of 360 U.S. stock funds; 149 of these no longer exist.

• 2005 expense ratios for funds tracking the S&P 500 Index: Industry average: 0.59%; Vanguard 500 Index Fund: 0.09% (Admiral™ Shares) and 0.18% (Investor Shares).

Look at that last stat and think of what a huge advantage costs are for the Vanguard index fund versus other mutual funds with 1-2% expense ratios. That means that those investments have to outperform the S&P 500 by almost 1-2% just to be even with the index fund on a total return basis. This is very difficult to do consistently and hence it's a key reason index funds regularly perform well over a long period of time.

Comments

[mike]

is it a typo that you like ETF's because they minimize capital gains? There is plenty of ways to get minimized capital gains, however that isn't usually how I make my investment decisions!

[FMF]

1. This is about index funds, not ETFs.

2. The entire section you're referring to (I think) is:

"A Random Walk, which went on to become a mainstay in personal finance publishing, proved to be prescient. By simply buying and holding the stocks listed in the Standard & Poor's 500 Index, the new Vanguard fund automatically maintained a diversified portfolio with low turnover, which in turn minimized costs and capital gains distributions. The numbers added up to sustainable advantages over higher-cost, actively managed funds."

It's not just capital gains related, but the quote focused on keeping all costs low (of which capital gains distributions are a part) which, in turn, leads to higher total investment return.

[Mike]

This is what I was referring to, "Yep. These are some of the reasons I like index funds. Low costs and minimized capital gains make it hard for other investment alternatives to beat index funds."

But, I think I now understand what you were trying to say.

[FMF]

Oh, I see. Maybe "minimized capital gains distributions" is better? ;-)

Guess one word does make a difference!