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People who invest their money in stocks can be split up into two categories. One category of people actively decide which stock they want to invest their money in. This means that these investors spend their time and money doing research on individual stocks. On the other hand, the other category of people invests their money but do not have the time or the inclination to pick individual stocks. These investors are called passive investors.
Common sense dictates that people who manage their money more actively should ideally get a better rate of return on their money. However, this is not what happens in reality. When empirical data is considered, the results are counterintuitive. It turns out that people who have been investing their money passively end up making a much better return on their investments. The ones managing their money actively are simply making too many mistakes while choosing their stocks. This is the reason why some of their bets pay off handsomely while others do not. In the end, they average less than people who invest their money passively.
This is the reason why Index funds like Vanguard and S&P are extremely popular with investors. When these funds were first launched, people thought that they were a surefire way to achieve mediocrity. However, over a period of time, these funds have become more acceptable.
In this article, we will have a closer look at the benefits that index funds offer over other investment options.
Picking individual stocks is risky as well as time-consuming. Many investors have full-time jobs. Hence, they do not have the time or the inclination to pick out the best stocks. Hence, if they invest in individual stocks, they are likely to make a mistake. On the other hand, when an investor invests in index funds, they immediately obtain a small slice of several different stocks. None of these stocks comprise more than 4% or 5% of the entire investment. Hence, the performance of individual stocks cannot really alter the performance of these funds. This approach of allocating the money amongst all the blue-chip stocks in the market has proved to be less risky and more rewarding since it facilitates diversification.
Index funds are more effective as compared to mutual funds. This is because of the extremely low expenses that these funds incur. Firstly, it needs to be understood that actively managed mutual funds have an entry as well as an exit load. This is done to make up for the marketing and advertising charges that are incurred by mutual funds. Since these charges are not incurred by index funds, they work out to be the cheaper alternative.
Also, mutual funds have to hire a research department whereas index funds do not have to do so. Since the job of index funds is only to mirror the markets, not much research is required. Also, index funds do not need to hire star index performers since the job of an index fund manager is only to mirror the market. Hence fancy management degrees and market-beating strategies are not required at all!
To sum it up, index funds can operate at less than half of the cost that is incurred by mutual funds. This is the reason why even if the gross return offered by the index funds may be less, they offer better net returns than most mutual funds.
Mutual funds have infamously used window dressing. Most mutual funds buy high performing stocks at the end of the reporting period. This allows them to report higher returns. However, the incessant buying and selling of stocks leads to higher rates of churn. Each time stocks are sold, the gains are liable for taxation.
Hence, in the process of churning stocks, mutual funds end up paying lot more in terms of taxes compared to index funds. Since the proportion of stocks in index funds tends to stay relatively stable over time, there is less churn and hence the tax paid is significantly lower. This is another reason why mutual funds work out to be cheaper than index funds.
There are many mutual funds in the market. Since they are all competing against one another, they have to employ the services of agents who help them to sell their units to investors. The problem is that mutual fund advisors tend to sell the funds which provide them the biggest commission. They are not really concerned with whether the fund will benefit the investor in the long term.
The good news about index funds is that they are relatively few in number. Most index funds do not use these salesmen to distribute the units. Since these funds are not aggressively sold, the chances of index funds being wrongly sold are relatively less.
Lastly, the track record of index funds is relatively easier to scan. Investors only have to find out which funds most closely mirror the index and they can invest their money. This is opposed to actively managed funds wherein investors have to consider various variables before they are able to zero down on a fund where they want to invest their money.
To sum it up, index funds are simpler and have historically provided returns which are comparable to mutual funds.
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