Index funds have become more popular among investors in the 21st century. Passive investing overall has become more popular to the point where passive management now accounts for almost 50% of all assets for U.S. stock-based funds, according to CNBC.
So, are index funds a good investment? Why are they becoming more popular? Why would Warren Buffet recommend index fund investing to the average investor?
All these questions, and more, will be answered in the following paragraphs.
What are Index Funds?
To know what index funds are, we first have to know what an index, alone, is. An index is a mathematical average that tells you how a specific group of stocks, commodities, or other securities is doing. In this case, we will mostly be focusing on stocks.
We actually use indices all the time in our lives for aspects outside of investing.
For example, if a group of people is trying to calculate the average fluctuations of weight within the group, that calculation is an index!
The same applies to our market. The fluctuation of the value of a group of securities is an index. In this case, an index fund is a basket of stocks that mirrors a particular index. When you purchase an index fund, you purchase a small percentage of each stock held within the index.
One of the most popular indices in the world is the S&P 500 Index. It calculates the average price fluctuations within the top 500 companies/corporations in the United States. By purchasing an S&P 500 Index Fund, you are purchasing a small percentage of each of the companies that are held within the S&P 500 for a fraction of the price.
A Common Misconception About Big Indices
In this example, we will be using the S&P 500 to explain a common misunderstanding of large indices. But keep in mind that nations all across the world have different indices, just like the U.S. does. They have big indices that track the majority of the nation’s market, as well as smaller ones.
The S&P 500 is one of the largest indices in the U.S., due to this, they tend to go hand in hand with the overall U.S. Economy.
It should be very well noted that the market or index performance does not reflect the performance of a nation’s economy. 2020 is a perfect example of this. Due to the occurrences of the pandemic, the U.S. economy did very poorly throughout this time.
The Gross Domestic Product (GDP) of the U.S. dropped by about 4% by June, unemployment skyrocketed, and people were in danger of losing their homes. Yet, the market and the S&P 500 only dropped for a couple of months, then picked right back up on their bull run, despite the economic distress.
Be very careful not to confuse a big market index with the economy of its nation.
It is a very common mistake, and even large finance influencers commonly have mistaken the two.
Index Fund: Pros
Index funds have many advantages over other funds. Here are some of them!
Great for passive investors.
First off, index funds are generally for passive investors. These are investors who prefer to do minimal work for their investments, while also having a decent return on investment (ROI).
When you’re a passive investor, you don’t want to spend your time researching a company to find its intrinsic value, what risks it faces, what growth potential it has, etc. Instead, your objective is to be able to invest in the market, obtain a safety of principal and an adequate return with the least amount of effort possible.
Index funds are a great option for the passive investor.
Index funds provide low operating expenses.
Due to the low-maintenance necessity of index funds, the average expense ratio for an index fund is about 0.2%. More often than not it could even be lower than 0.2%. Compare this to mutual funds, you get an average expense ratio of about 2%.
Believe it or not, this has a huge impact on your returns. Expense ratios and fees can eat away quite a bit from your average return.
This is why having an index fund with an expense ratio lower than 1% is an excellent option. You won’t have to pay so much in fees because the expense ratio for your fund is very low.
Index funds have outperformed actively managed funds
Warren Buffet actually made a bet of $1M against a collection of professional hedge fund managers. He bet that the hedge fund managers could not beat the general market index over a 10-year period…
Warren won the bet, as the hedge fund managers were not able to beat the market index.
92-95% of professional fund managers cannot beat the general market index over the long run. One recent example is from SPIVA Scorecard data from S&P and Dow Jones Indices. During a five-year period, ending December 2018, 82% of large-cap funds generated a return less than the S&P 500.
Many more examples across history have proven many times that the majority of actively managed funds cannot outperform the market in the long run.
Index funds offer ultimate diversification. You can choose how much you want to diversify your portfolio from the specific index funds you choose.
Keep in mind that index funds don’t only follow stocks. There are funds for other types of securities as well. Some examples are commodities, bonds, and even real estate. Your options are nearly limitless when it comes to diversifying with index funds.
Index Fund: Cons
Although index funds have many advantages, they aren’t quite perfect. They have their downsides and while these may not be significant enough for some people, for others it could mean the deciding factor of whether they will invest with index funds or not.
Vulnerable to market volatility
Since index funds are meant to mirror a specific index, they are susceptible to the same volatility as that index. Also, since index funds are meant to be long-run funds, the short term volatility of their index makes them less attractive than actively managed funds.
This is because actively managed funds are better equipped to defy short-term volatility. Actively managed funds tend to do better in the short-term, passively managed funds tend to do better in the long-term.
According to the SPIVA Scorecard, in a span of one year, only 64% of large-cap mutual funds underperformed the S&P 500. In other words, over one-third of them beat it in the short term.
With this being said, keep in mind that expense ratios are far higher for actively managed funds, and depending on your gain, you might still be better off investing in index funds.
Lack of flexibility
Due to the fact that index funds follow an overall index, once you purchase an index fund you have invested into all the securities within it, even if you don’t like some of those securities. Those securities are part of the fund and your money will be going into them regardless.
Also, if you want to purchase other equities along with your index fund but they are not part of the index, then you will have to make this purchase separately. This isn’t’ too much of a big deal though, you can purchase fractional shares if you can’t purchase the entire equity. Or if you can afford them, simply buy the separate equities in full. Just keep in mind that they aren’t part of that index!
The gains of your index funds are limited to that of the gains of the index. This means that if one security did amazing within the index fund, your gains will still match the overall index rather than that specific security. Some investors are looking for above-average returns from their investments, you won’t usually be finding that with index funds.
Why Warren Buffet Recommends Index Funds
“The best, single thing you could’ve done on March 11th, 1942, when I bought my first stock, is buying an index fund and never look at a headline. Never think about stocks anymore. If you put $10,000 in an index fund with reinvested dividends, it would’ve come to about $51,000,000 today” – Warren Buffet in 2018.
The legendary investor, Warren Buffet, could not have explained it more clearly. Index funds were not a thing until the 1970s, but had they been around in 1942 when Warren started investing, he would’ve bought in. The reason for this is because, over the long run, history has shown us many times that very few can outperform the market.
No one can accurately predict the market for a long period of time. If the most professional hedge fund managers and mutual fund managers in the world cannot beat the market on a 95% basis over the long run, what can make an ordinary investor believe that he or she will do better?
Unfortunately, it’s all luck when it comes to outperforming the market on a consistent, long-term basis.
If you ignore the headlines and simply keep investing consistently, you will be greatly rewarded in the long run. Yes, in the short run you will see tremendous down-dips, but don’t let the emotional part of you take over what should only be a logical approach to investing.
If the most successful billionaire investor is telling you to invest in index funds, maybe it’s something you should consider.