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Thayer Partners Blog

What Is Index Investing and How Does It Work?

[fa icon="calendar"] Mar 25, 2016 9:30:00 AM / by Chris Wilmerding

Chris Wilmerding

What_Is_Index_Investing_and_How_Does_It_Work.jpgInvesting can be complex. There are so many options to choose from, so many investment risks to consider, and the stakes are undoubtedly high. If you’re considering investing in the stock market, you might have heard that index investing is a low cost and tax efficient way to go. If you want to know what it is and how it works, keep reading.

Indexes and Index Funds

Indexes are great tools in the stock market that allow us to see how a market or an industry segment is performing. And you can buy into these investment vehicles through the purchase of index funds.

Index funds are, put simply, mutual funds or Exchange Traded Funds that are based on one of these indexes of stocks and replicate its performance in the market. However, these funds can also replicate other types of investment, such as bonds or a narrow subset of the market, like US small-cap biotech companies.

This type of low-cost mutual fund was created based on a belief (supported by academic research) that it is nearly impossible to consistently beat the market. Essentially, it was created with the idea that the best way to beat the market is to get the market because most people do not have the acumen to pick stocks that beat the broader market index.

These funds work by identifying a well-known index then building a fund that either owns representative positions in the identified index or achieves the same end by holding similar securities.

Index Funds vs Actively Managed Mutual Funds

The mutual fund industry has been telling us for years that, to achieve superior returns on mutual funds, we must enlist the help of professional portfolio managers. Unfortunately, due to the fact that you have to pay for the high salaries of these managers, trading costs, and taxes, mutual funds fail to outperform the S&P 500 anywhere from 50% to 90% of the time. Currently, 89% of U.S. equity actively managed funds and 90% of U.S. fixed income actively managed funds underperform their respective benchmark over a 10 year period.

Index funds, however, offer three key advantages compared to a regular mutual fund: lower fees, lower taxes and lower trading expense. Where you’d pay an expense ratio of approximately 1.5% for an average non-index mutual fund, you’ll only pay an expense ratio of around 0.2% with index investing. Why? Because the index fund isn’t actively managed. Index funds can be passively managed by computers that maintain the right weightings to match the index performance. Since this type of mutual fund owns all of the investments in the index, you’re not hiring high salaried portfolio management teams to pick a winner or a loser; therefore, there is a lot less expense required to maintain and run an index fund.

Typical Returns

Index investing certainly doesn’t guarantee that you’ll never lose money. You’ll still go up in a bull market and down in a bear market. However, you will get the return of the underlying index, less expense and tracking error.  For example, the return of the S&P 500 ranges from 6% to 10%, depending on the time period.

The key is investing for the long term. If you invest your index funds over the long term, you’ll benefit (assuming the market goes up in that time period); but if you panic and sell during a downturn, you’ll probably miss the recovery.

Why Choose Index Investing

If you’re looking for a cost-and tax-effective way to invest in the stock market, index investing should be considered. The lower costs associated with passive index funds and their ability to mirror the performance of markets (or nearly mirror) may contribute to long-term investment success. With lower index fees, you may be able to keep more of your retirement nest egg for you and pay less out to Wall Street.

When you buy the market instead of individual stocks, you will not have to worry about the performance of a particular company, just the performance of a broader market. But remember, index investing in a long-term investment strategy. With no bells or whistles attached, index investing is a solid investment approach at a rock-bottom price.

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Topics: Index Investing

Chris Wilmerding

Written by Chris Wilmerding

Chris Wilmerding is Principal of Thayer Partners, an independent investment management firm located in Westwood, MA providing financial planning and wealth management counsel to individuals and their families.

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