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Lowered expense leads to better performance. Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds. It is true that a majority of mutual funds fail to beat broad indexes. For example, during the five years ending December 2019, 80% of large-cap funds generated a return less than the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices.1
On the other hand, passively managed funds do not attempt to beat the market. Their strategy instead seeks to match the overall risk and return of the market—on the theory that the market always wins.
Passive management leading to positive performance tends to be true over the long term. With shorter timespans, active mutual funds do better. The SPIVA Scorecard indicates that in a span of one year, only 70% of large-cap mutual funds underperformed the S&P 500. In other words, over one-third of them beat it in the short term. Also, in other categories, actively managed money rules. As an example, nearly 70% of mid-cap mutual funds beat their S&P MidCap 400 Growth Index benchmark, in the course of a year.2
Even over the long term, when an actively managed fund is good, it is very, very good. Investor's Business Daily's "Best Mutual Funds 2019" report lists dozens of funds that have racked up a 10-year average total return of 15% to 19%, compared to the S&P 500's 13.12%. They've significantly outperformed the market in one-, three-, and five-year periods, too. Admittedly, this a feat that only 13% of the 8,000 mutual funds out there can claim, as detailed in the report.
Real World Example of Index Funds
Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2018, according to Morningstar Research, investors poured more than US$458 billion into index funds across all asset classes. For the same period, actively managed funds experienced $301 billion in outflows.3
The one fund that started it all, founded by Vanguard chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. It posts a one-year return of 7.37%, vs. the index's 7.51%, as of July 2020, for example. For its Admiral Shares, the expense ratio is 0.04%, and its minimum investment is $3,000.4
Frequently Asked Questions
What is an index fund?
An index fund is an investment product that aims to match, rather than exceed, the performance of an underlying index. Examples of the kinds of indexes tracked by index funds include the Standard & Poor’s 500 Index, better known as the S&P 500; or the Dow Jones Industrial Average (DJIA). Index funds have grown in popularity in recent years, as a growing number of investors have adopted passive investing strategies. One of their main strengths is the low fees that they charge relative to active investment funds.
How do index funds work?
Index funds are often structured as exchange-traded funds (ETFs). These products are essentially portfolios of stocks that are managed by a professional financial firm, in which each share represents a small ownership stake in the entire portfolio. For index funds, the goal of the financial firm is not to outperform the underlying index but simply to match its performance. If, for example, a particular stock makes up 1% of the index, then the firm managing the index fund will seek to mimic that same composition by making 1% of its portfolio consist of that stock.
Do index funds have fees?
Yes, index funds have fees, but they are generally much lower than competing products. Many index funds offer fees of less than 0.20%, whereas active funds often charge fees of over 1.00%. This difference in fees can have a large effect on investors’ returns when compounded over long timeframes. This is one of the main reasons why index funds have become such a popular investment option in recent years.
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