What The Heck Is An Index Fund?

From an early age, we’re taught to celebrate winners.

Look up to champions.

Revere Gold-medalists.

We make fun of “participation trophies”.

I mean, when was the last time you heard somebody bragging about having a few dozen followers or a perfectly average salary?

So how do you explain the explosion in popularity in an investment tool that offers nothing more than a guarantee of average results?

Nothing fancy… just average.

Strange as it might seem at first glance, the meteoric rise of the “Index Fund” is a lesson in how sometimes, aiming for “average” might be the “best” strategy of all.

In an earlier episode, we explained how mutual funds offer numerous benefits — like low share prices, broad diversification, convenience, and ease.

Their debut in 1924 ushered in a golden age for active portfolio managers.

Professional investment management was suddenly no longer just for the ultra-wealthy.

The American middle class poured their savings and retirement accounts into mutual funds with abandon.

Today, with nearly 10,000 mutual funds available, it can look like a Cheesecake Factory menu, endlessly long and complicated.

So most fund managers compete to deliver the maximum amount of “alpha”.

That’s just investor-speak for how much BETTER the portfolio manager did than the market average.

The way managers measure their success is by comparing their returns to an “index”.

An index is a hypothetical portfolio that represents a segment of a financial market.

For example, the S&P 500 index measures the average stock gains or losses of the 500 largest companies in the US.

There are indices for virtually every type of investment all across the world: precious metals, oil, bonds, even a pork carcass index.

Their main use is as a comparison tool.

For a long time, trying to “beat the index” with your mutual fund made sense to most investors.

I mean, who would want to put their money with a fund manager who charged expensive fees but failed to beat the market most of the time?

But then, a dirty little secret was uncovered.

Most professional fund managers consistently fail to meet-or-beat their index by a wide margin.

One study found that, 90% of active-fund managers did worse than their relative index.

And these are supposed to be the best of the best with Ivy league educations, decades of experience and sophisticated trading tools.

There are a few factors that make it difficult for fund managers to “beat the market”.

The first is fees.

Actively managed mutual funds employ teams of researchers, analysts, and traders.

That costs money.

And you, the investor, end up paying for it.

Actively managed funds have annual fees on average of around 1.4%.

In other words, your mutual fund has to make 1.4% per year just to keep you from LOSING money!

A second key factor is that humans are really really bad at telling the future.

In the 1973 book, “A Random Walk Down Wall-street”, Burton Milkier suggested that investment markets are too complicated and, well, random, to be consistently predicted.

Researchers found that you’d do just as well picking stocks blindfolded as you would giving your money to a portfolio manager.

No seriously, in a contest run by the UK Observer, professional portfolio managers tested their skills against the stock-picking prowess of a cat named Orlando.

Orlando shredded the pro’s.

Milkier suggested the creation of a new, low-cost mutual fund that simply buys the hundreds of stocks within the index, and doesn’t jump from stock to stock, trying to beat the market.

That sounded like a great idea to a guy named John Bogle.

In 1975, he launched Vanguard’s “First Index Investment Trust”.

No more promises of beating the market — the only guarantee was that your investments would do slightly worse than average (since even index funds have minimal fees).

Sound a little… underwhelming?

Yeah, it did to investors at the time too.

The fund was ignored - or outright mocked - for years, and many thought it wouldn’t survive.

Spoiler Alert: it did.

Over the last half-century, more and more investor’s started wising up and today Index Funds and Index ETFs are more popular than ever with nearly 7 trillion dollars resting in index-type funds.

It seems the promise of consistently “average” results doesn’t sound so shabby to investors any more.

This is also thanks to the investing Godfather…Warren Buffet.

In 2007 he made a million dollar bet with the world’s best hedge-fund managers that they couldn’t out-perform an S&P 500 Index Fund over a 10 year period.

And wouldn’t you know it, despite weathering the 08 crash, the index fund trounced the hedge funds, averaging an annual 7.2% return, compared to the hedge funds measly 2.2%.

Now, to be clear, index funds are not the “perfect investment.’’ There is no such thing.

But Warren Buffett famously quipped that Index-Fund investing is the best move for 99% of investors out there.

So if you decide to join the club, start simple and don’t forget to diversify!

For example, a basic blend of three broad indices would allow you to diversify into a huge spread of countries, companies, and asset types.

Index funds are available through most fund-companies and can be bought within a retirement account like an IRA or 401k.

And unless you’re a seasoned investor, speaking to a professional to set an ideal blend is a smart step.

There are also online “robe-advisor” services that can automatically make the blend for you, based on your goals and risk tolerance.

So next time your momma asks if you’re doing your best, say… actually Warren Buffet says that I should just strive to be average!

She’ll be thrilled.

And that’s our two cents!