Investing Basics: Index Funds

Consider the problem facing most retail investors. They have to buy a company, hopefully at a price lower than the firm’s value, then sell it at some future date to someone who will pay a premium.

Troublesome as that is, it gets worse.

Aside from the opacity of even public firms, our investor must also take into account irrationality among other investors. Regulation comes into play, as well as pressure from competitors.

To top it all off, the retail investor must go through the markets to buy and sell, paying a toll in the form of trading commissions. Dividends partly recompense us for the effort, but those can be cut.

No wonder we tend to shrink from so grand a responsibility. Wall Street knows we cannot focus on the minutiae of investing, so it came up with the mutual fund concept: Give us your cash and we’ll worry about pricing and competition and even deal with the trading costs.

It will all be wrapped up in a small fee, so small you might not even notice. Except the fee is not small. Mutual funds charge, all in, around 1.44% for equity funds and 1.02% for bond funds. Some emerging market and alternative funds are 2% or higher, according to the Investment Company Institute.

Fee impact

Let’s say you average out to 1.5%, which is a typical experience for a portfolio of funds and doesn’t count whatever extra you voluntarily pay a financial advisor. The impact of that 1.5% on your return is enormous, between one-third and one-half of the potential gain over 20 years of saving and investing.

Worse still, you aren’t likely to get any upside. Most mutual funds have trouble keeping up with their own benchmarks, much less beating them. The S&P 500 regularly bests 70% of actively managed equity funds. Bond funds do even worse.

Index funds solve all of these investing risks in a single shot. Here’s how:

1. Stock selection

First off, you no longer have to pick stocks. An index fund by design owns all of the stocks or bonds in a given index. It uses computers to buy, sell or hold assets in accordance with the market itself. If you own an index fund of the U.S. broad stock market, say the S&P 500 or the Wilshire 5000, you own all of those companies.

2. Cost

Index funds in the form of exchange-traded funds (ETFs) are rock bottom on pricing, as low as 0.04% but often in the vicinity of 0.05% to 0.07%. The pressure is on the big brokerages, too, to cut commissions to zero in order to attract clients. Win-win, as they say.

3. Performance

You get the return of the index, minus a minuscule fee to keep the computers running and your investments in line with the market. The result is a consistent return, one you can bump up by owning a balanced portfolio and periodically rebalancing among asset classes.

Increasingly, index funds are a powerful tool that even beginning investors can use to ensure that they retire on time with little stress. You don’t need to beat the market. You just need to keep up, keep costs down and make as few mistakes as possible.