Intro To Index Funds
Zack O'Malley Greenburg, 04.16.09, 6:00 PM ET
Crash. Disaster. Meltdown. These are some of the words used to describe the stock market lately.
Forget all that. Despite the recent pain, stocks have gained 8.7% per year on average over the past 80 years. If that's not enough to convince you, consider what a great deal stocks are these days compared to a year an a half ago, when they were trading for nearly double the price.
For most investors, the best way to own stocks is via an index funds. These are mutual funds that give you broad stock market exposure for a rock-bottom cost and with superlative tax efficiency. The alternative: actively managed funds, which charge several times more and run up hefty tax bills in a usually vain bid to beat the market.
Index and actively managed mutual funds can both be purchased directly from a vendor like Vanguard, Fidelity Investments or T. Rowe Price. Many brokerage accounts also make them available, but beware of sales loads, or commissions, if you buy this way. If your employer offers a 401(k) retirement account, it probably offers index funds as a way to get exposure to hundreds of individual stocks with a single purchase.
What distinguishes index funds is that they don't presume to have greater wisdom than the collective market but instead try to channel its wisdom to your advantage. The most widely owned index in the U.S. is the Standard & Poor's 500, which includes 500 of the nation's largest public companies.
In contrast, actively managed funds are run by money managers who aim to beat the market by buying and selling individual stocks based on their own criteria. With thousands of managers plying this trade, some invariably beat the market each year. Those are the ones who tend to get lauded as geniuses by a gushing financial media. Most fail dismally and with little fanfare.
Picking the relative handful of managers who will beat the market in advance is a sucker's bet that preys on investors' inherent optimism and over-confidence in their abilities. The only consistent winners at this game are the fund firms that rake off billions of dollars in fees.
"We prefer index funds to actively managed funds," says Mary A. Malgoire, president of The Family Firm, a financial advisory in Bethesda, Md. "At least the indexes save you the management fees. Otherwise, it's like running a marathon in cement shoes. The fees just drag you down."
Rare is the fund manager who can consistently beat the market--and those are getting rarer. According to a 2006 study by economists Laurent Barras and Russell Wermers of the University of Maryland and Olivier Scaillet of the University of Geneva in Switzerland, just 14% of active managers beat the market by a statistically significant margin in 1990. By 2006 the figure had plunged to 0.6% after fees, thanks to the rising fees charged by mutual funds.
Management fees for actively managed equity mutual funds run around 1.5% on average--on a straight-line basis, not the lower asset-weighted one the industry likes to tout. That's 15 times the 0.1% you'll pay to track a market index via a low-cost mutual fund or exchange-traded fund (ETF).
The 1.4 percentage point difference may not seem like a lot, but it adds up over time. Let's say you invest $5,000 in a mutual fund that charges a 1.5% annual fee. In 20 years, assuming an average growth rate of 8%, your $5,000 will have grown to $17,225. Sounds great, but not compared to the $22,843 you'd have had if you'd invested the same amount of money in Fidelity's Spartan 500 index fund, whose fee is 0.1% for a minimum investment of $10,000 in a regular account or $500 in some retirement accounts.
Look at it another way: Over the course of 20 years, owning that expensive mutual fund means paying $3,100--more than half of your initial investment--in fees. That's not even counting the additional money you'd have made if you'd reinvested that $3,100 instead of handing it over to the fund's managers.
By contrast, that inexpensive index fund would cost you just $244 in fees over the same time period. (The SEC offers a cost calculator if you'd like to run the numbers yourself.)
The same rules apply when choosing between various index funds. Shop for the cheapest one that fits your needs. Vanguard offers some of the most reasonable index funds. The Vanguard Total Stock Market Index Fund (VTSMX) and the Vanguard 500 Index Fund (VFINX) each offer broad U.S. stock exposure for 0.15% a year and require minimum initial investments of $3,000.
For international exposure, the Vanguard Total International Stock Index (VGTSX) or iShares' MSCI EAFE Index Fund (EFA) each charge 0.34% fees.
Once you've formed the core of your portfolio with index funds, if you can't resist the temptation to try and knock out the lights, consider an actively managed mutual fund with a solid long-term record and the same manager in place who posted the alluring numbers. For a list of prospects, see the Forbes Honor Roll.
"Do your gambling in Vegas," says Malgoire. "Just get your money in the market, don't try to be brilliant."
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