Indexing is a passive investment strategy that tracks a benchmark, such as the S&P 500. A S&P 500 index fund attempts to match the return of the S&P 500.
An index fund is considered a passive investment because it follows an index. Index funds use computer models to buy and sell investments based on the holdings in the index they are tracking. In contrast, an active fund has a manager who picks investments, typically based on research and analytics. The active fund manager relies on his or her research, experience and personal judgments to make decisions about what stocks, bonds and other investments to buy and sell based on the objective of the fund.
Index funds can be purchased as a mutual fund or an exchange-traded fund. Both types of index funds have the same objective, but they are very different in nature. A mutual fund is priced once per day after the market closes, while an exchange-traded fund trades on an exchange like a stock during open market hours.
Here’s why index funds should be part of your retirement portfolio:
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1. Index funds often outperform their actively managed peers. Actively managed funds generally fail to beat their benchmarks, especially over the long term. In the short term, the performance of active funds is mixed. Just under half (49 percent) of active U.S. stock funds beat their composite passive benchmark for the 12-month period that ended June 30, 2017, compared to 26 percent for the year that ended Dec. 31, 2016, according to Morningstar’s Active/Passive Barometer. But if you look at a longer time horizon, passively managed index funds tend to outperform actively managed funds in the same investment class. For example, just 7.1 percent of actively managed U.S. large-cap funds that existed 15 years ago managed to both survive and outperform the average passively managed fund with the same objective.
2. The fund follows a consistent plan. A major advantage of using index funds is that you always know exactly what you are invested in because the fund follows a consistent passive strategy. If you purchase an actively managed fund with the same objective, the fund manager and his or her team can often invest a percentage of the fund in different holdings than the main objective of the fund. The prospectus often allows the fund manager to invest a certain proportion of the fund’s assets in holdings that aren’t necessarily aligned with the strategy of the fund.
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3. Low costs. Investment expenses can significantly erode the value of your portfolio over time. The average equity index fund expense ratio is 0.28 percent, while the average expense ratio of actively managed equity funds is 0.88 percent, according to a Vanguard analysis of Morningstar data. And it isn’t difficult to find index funds that cost much less. Many index funds have expense ratios lower than 0.1 percent. High fees mean you get to keep less of the returns generated by the fund.
4. Diversification. You can get broad investment exposure and be properly diversified buy purchasing just three index funds: a S&P 500 index fund, an international index fund and a U.S. bond market index fund in proportions that meet your risk tolerance. These three index funds will give you access to the returns generated by thousands of stocks and bonds. The diversification index funds provide helps protect against broad market declines and reduces the risk of any one stock or bond producing a dramatic decline in your overall returns.
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5. Low transaction costs. Index funds are simply tracking a benchmark, so there is little need to make frequent changes to the holdings. Index funds generally buy and sell investments within the fund much less often than actively managed funds. This helps reduce fees that are generated each time a trade in the fund occurs. Fewer internal transaction fees helps to keep investment costs down and often means higher returns for investors.
Joseph Carbone Jr. is a certified financial planner and founder of the Social Security Teacher blog.
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5 Reasons to Use Index Funds in Your Retirement Accounts originally appeared on usnews.com
