As you embark on your journey to build wealth through mutual funds, you may wonder which to choose: actively managed mutual funds or passively managed mutual funds. If you are new to investing, the idea of a passive fund might seem odd, maybe even lazy. In fact, the idea of paying a trusted fund manager to monitor and trade your investments might seem like a better option if you're not quite sure what you're doing, but the choice isn't quite that simple.
Here are some reasons why you might want to think about passive index fund investing as a long-term strategy.
What Is An Index Fund?
Before you add an index fund (or any other investment) to your portfolio, you should know what it is and how it works. An index fund is a mutual fund or exchange-traded fund (ETF) designed to mirror the performance of a major index like the Dow Jones Industrial Average, S&P 500, or Nasdaq. When you purchase a share in one of these funds, you are actually buying a small piece of a number of stocks at once.
Index funds are passively managed. This means the fund manager picks an index to track and then simply copies its holdings. They may check in when the index has changed its holdings, or some other major event, and rework the balance of your holdings. But for the most part your portfolio will stay as it is.
For instance, an investor that buys a Vanguard S&P index fund designed to mirror the S&P 500 will adopt the S&P risk. When the S&P gains, then the investor's S&P index fund will rise by almost exactly the same amount. When the S&P falls, their portfolio will suffer the same decline.
Note
In funds that are actively-managed, the fund manager plays an active role in choosing stocks. They study many single stocks (and the market as a whole) based on complex factors, and make choices and trades to try and do better than an index. Of course expert advice comes with a price tag.
How Index Funds Can Help You Skip the Analysis
Index funds are ideal for those who are new to the market, and who may lack the skills or knowledge to assess a company's finances or compare corporations. With an index fund investment strategy, you don't need to pour over income statements from a balance sheet. You don't need to calculate discounted cash flows or any analysis ratios. In fact, if these terms seem daunting, rest easy because you can simply follow the lead of an index.
Diverse Holdings
The point of watching all these metrics in the first place is to avoid placing your money with risky companies. With an index fund, you don't need to worry too much about the risk from a single company. This risk is reduced by the fact that you're buying dozens or even hundreds of companies with a single fund share.
How Index Funds Can Help Lower Your Costs
Actively managed mutual funds rely on a team of managers and analysts that decide what trades to make. All of these people must get paid, and even if a single fund manager handles most of the duties, the fees will still add up. Your costs amount to a percentage of the fund's assets each year, and they are taken from the fund before you receive your share. This is known as the expense ratio.
Small Expense Ratios
Index funds may have a manager, but that manager will do far less. All they have to do is check in on the holdings form time to time, and ensure that they still mirror the underlying index. Since they do less, these managers get paid less. This means that you can reduce the amount of your portfolio that goes into a fund manager's pocket. This effect compounds in the long run.
Note
For a closer look at fees, take for instance Vanguard's passive index fund that tracks the S&P (VOO). The expense ratio of this ETF is only 0.03%. Compare that to Vanguard's Growth and Income Fund (VQNPX), which attempts to beat the S&P 500 and comes with an expense ratio of 0.33%.
No Broker Fees
Another way that index funds save you money is how they reduce brokerage commissions. If you wanted to replicate the portfolio of an index fund (without simply buying shares in the index fund), you would have to buy all those companies on the index, one by one. That could mean dozens or hundreds of trades, which would not only cost a large amount of cash, but would also be charged a broker's fee for each trade.
How to Combine Dollar-Cost Averaging With Index Funds
Index investing works well with a dollar-cost averaging strategy. This is a tactic that consists of making small and steady investments over the long-term, and sticking with it, no matter how the market is doing. In practice you might buy a few shares of a single stock (or fund) at frequent intervals. When stocks are up, you buy. When stocks are down, you buy. The goal is to reduce risks related to market timing by investing regardless of how stocks are performing.
This concept of spreading market timing risk is much like that of spreading the company-specific risk. Combined, even the most inexperienced investor can develop a well-balanced portfolio that doesn't expose itself too heavily to any one risk.
Key Takeaways
- Index fund investing uses passively managed funds to invest in major stock indices.
- You won't need an in-depth knowledge of accounting, financial theory, or portfolio policy, to invest in index funds.
- You can count on a diverse array of holdings, since index funds contain dozens or hundreds of companies. This diversification reduces company-specific risk.
- Index funds have very small expense ratios, which provides a major edge over actively managed funds. The money you save on fees will compound over time, and add to your fund's gains.
FAQs
If you invest in an index fund, you get a chance to diversify your portfolio and achieve long-term growth. These funds are simple, cost-efficient, and transparent investments that can offer you the best returns on your money.
Why invest in low cost index funds? ›
Lower costs: Index funds typically have lower expense ratios because they are passively managed. Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.
Why do investors invest in index funds? ›
Why are index funds so popular with investors? Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost.
Why are index funds such a popular investing option responses? ›
An index fund is a type of mutual fund or exchange-traded fund that aims to mimic the performance of an index, such as the S&P 500®. Index funds tend to offer investors lower costs and taxes than some other types of funds. They're also relatively lower maintenance.
Why are low investment fees so important for individual investors? ›
Although you earn 8% gross returns, your net return will be reduced by the amount of fees you pay. The higher the fees, the lower the return you actually receive. A common retirement goal is to be able to withdraw between 3% and 5% of an investment portfolio each year during retirement.
What are the best low cost index funds? ›
10 Best Low-Cost Index Funds to Buy
| Fund | Expense Ratio |
|---|
| Fidelity 500 Index Fund (FXAIX) | 0.015% |
| Fidelity ZERO Large Cap Index Fund (FNILX) | 0% |
| Vanguard S&P 500 ETF (VOO) | 0.03% |
| iShares Core U.S. Aggregate Bond ETF (AGG) | 0.03% |
6 more rowsApr 29, 2024
How do index funds work? Index funds don't try to beat the market, or earn higher returns compared to market averages. Instead, these funds try to be the market — by buying stocks of every firm listed on a market index to match the performance of the index as a whole.
What is the main advantage of index funds? ›
There are also several advantages to index funds. The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. Exchange traded funds (ETFs) are often index funds, and they generally offer the lowest fees of all.
What are 3 advantages to index fund investing? ›
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
What are low cost index funds? ›
Low-cost index funds are an inexpensive way for people to build a diversified investment portfolio. These funds are suitable for both new and experienced investors, and the best low-cost index funds allow you to meet your investment goals while aligning with your risk tolerance and investment time horizon.
Index funds tend to be low-cost, passive options that are well-suited for hands-off, long-term investors. Actively-managed mutual funds can be riskier and more expensive, but they have the potential for higher returns over time.
Why are index funds better than active funds? ›
Index funds offer lower fees and tax efficiency. Due to their passive nature, they often perform in line with market benchmarks, making them suitable for investors seeking broad market exposure at lower costs. On the other hand, active mutual funds aim to outperform the market by employing active management strategies.
Why does Warren Buffett like index funds? ›
Buffett's thinking here is straightforward. Most non-professional investors (and even many professional stock-pickers) have very little chance of outperforming the market. But index fund investors get exposure to the entire U.S. market and can benefit from its historical upward trajectory — and for cheap.
Why do investors like low interest rates? ›
Lowering rates makes borrowing money cheaper. This encourages consumer and business spending and investment and can boost asset prices.
Why do small investors use mutual funds? ›
There are several specific reasons investors turn to mutual funds instead of managing their own portfolio directly. The primary reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
Why should beginning investors choose low risk investments? ›
Low-Risk Investment
There is also less to gain—either in terms of the potential return or the potential benefit bigger term. Low-risk investing not only means protecting against the chance of any loss, but it also means making sure that none of the potential losses will be devastating.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Is it wise to only invest in index funds? ›
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
Should I invest in VFIAx or VOO? ›
Investors who prefer to trade during the day to take advantage of price fluctuations may prefer an ETF like VOO, whereas a more passive buy-and-hold investor may prefer a mutual fund like VFIAX. Investors using a taxable brokerage account may prefer VOO because tax implications are another important factor to consider.
