Investors have long sought to outperform the stock market, which has historically returned around 10% per year on average. While some have certainly achieved greater returns, identifying the right investments to do so is a difficult game — and one that, in most cases, proves to be a losing effort.
The good news? Passively managed index funds have been shown to outperform actively managed mutual funds for a fraction of the cost.
What is an index fund and how does it work?
An index fund is a fund that tracks major indexes like the S&P 500 and the Dow Jones Industrial Average (DJIA). The fund’s goal is to match the performance of these benchmarks. For example, the S&P 500 is made up of the 500 largest publicly traded companies in the United States. Each company is given a specific weight. Apple, as an example, takes up approximately 5.86% (this number fluctuates) of the S&P 500 index. In contrast, a company like Halliburton only makes up .05% of the index. When you invest in an index fund, the make-up of the portfolio will be similar to the index it is tracking and is commonly known as “the market.”
One of the biggest benefits of investing in an index fund is instant diversification. When you invest in a single stock, your money is tied to the performance of one company. If that company does well, you do well. If that company does poorly, so does your investment. When you invest in an index fund like the S&P 500, you are instantly invested in numerous companies across multiple industries. That diversification significantly reduces the risk that any single company can derail your portfolio.
Passive vs. active — what’s the difference?
An index fund is a type of passive investment. Rather than actively selecting individual stocks, the fund simply aims to mirror the performance of its underlying market index — replicating its returns as closely as possible.
In contrast, mutual funds are typically managed by a fund manager (active), and the manager hand-picks stocks in an attempt to beat “the market” to produce greater returns for the investors. Not all mutual funds are actively managed, though the two have historically been seen as synonymous.
Since index funds are passively managed, they typically come with lower fees compared to a mutual fund. Index funds typically charge about 5 basis points (.05%) annually versus a mutual fund, which can charge upwards of 100 basis points (1.0%) or more. The higher fees stem from the cost of having fund managers actively oversee the portfolio.
For context, a basis point is a fancy finance term used to describe percentage points. For example, 1 basis point is equal to .01%.
While the basis points may not seem like a big deal, as your portfolio grows, those fees can eat into your overall returns. For example, if you had $1,000,000 in our portfolio, and an index fund is charging 15 basis points (.15%) and a mutual fund is charging 50 basis points (.50%), the fee breakdown is as follows:
$1,000,000 x .0015 = $1,500 per year
$1,000,000 x .0050 = $5,000 per year
Consider the math: over 20 years, you could be paying $100,000 in fees compared to $30,000 — money that could have been reinvested to compound your returns. Yet many investors remain unaware of the expense ratios they’re paying.
The above illustration is significant, but only with the right context. In theory, paying higher fees for a professional portfolio manager should yield superior returns, right?
History does not paint that picture. Over the past 15 years, about 90% of actively managed large-cap funds underperformed compared to the S&P 500. Based on the historical data, not only are you paying more in fees with a mutual fund, but the fund is largely going to underperform the market. In other words, the returns of most actively managed mutual funds don’t justify the higher fees. Based on the data, if you were invested in an S&P 500 index fund, you would outperform actively managed large-cap mutual funds approximately 90% of the time, while paying less in fees.
Index funds have grown dramatically over the years, as they now make up about half of all U.S. fund assets. So it appears that others are catching on, and have been for many years now.
Why index funds make particular sense for founders
Index funds can be particularly useful for founders. Think of an index fund as a “set it and forget it” type of investment strategy. Since the fund is tracking a particular market index, the fund will automatically rebalance if there are any significant shifts in the market index. Given a founder’s busy schedule, passively managed funds are a good, low-maintenance investment.
If you’re new to investing, index funds are worth serious consideration. It is low cost, easy to manage, and as the data shows, it outperforms active managers by a landslide. Even for more seasoned investors, index funds can serve as a home base — the foundation everything else is built around. From there, if you have money to spare and want to explore other options, taking a calculated risk isn’t the end of the world, as long as it doesn’t interfere with your short- and long-term goals.
Getting started doesn’t require a large sum of money. Many index funds allow you to start with as little as a few hundred dollars — some even have no minimum at all. You can also automate your contributions, setting up recurring deposits so your money moves without you having to think about it. And if you invest through a tax-advantaged retirement account like an IRA or 401(k), you may be able to reduce your tax burden at the same time.
A word of caution
The S&P 500 has long been considered the “gold standard” of market indexes. However, a large percentage of the index is tech stocks — and that concentration is worth noting. Technology is a sector that continues to grow year over year, and I am not suggesting you avoid it. But if the S&P 500 is your only investment, you may be overexposed to one sector more than you realize.
This is where diversification becomes important — and honestly, it is where a wealth advisor can add real value. If someone is invested in an S&P 500 index fund, I might look at their other accounts and adjust those to complement it — perhaps tilting toward developing or emerging markets, or adding more small and mid-cap exposure to balance things out. The goal is to make sure the overall picture is well diversified, not just the individual fund.
Fortunately, there are index funds that track different indexes beyond the S&P 500 — global markets, small and mid-cap, and others. Consider the makeup of the particular funds and determine if they meet your short-term or long-term goals.
It is also worth noting that index funds are not risk-free. When the market drops, your index fund drops with it. They are a strong long-term strategy — not a get-rich-quick solution. The key is staying invested through the ups and downs of the market and resisting the urge to sell when markets get turbulent. As many have said before me, it’s not about timing the market; it’s about time in the market.
And don’t take my word for it. Warren Buffett, arguably the greatest investor of all time, said, “A very low-cost index is going to beat a majority of the amateur-managed money or professionally managed money.”
*This is not meant to be investment advice and is for general information purposes only.
Ready to build a low-cost, long-term investment strategy tailored to your goals as a founder? Schedule a free consultation with Texel Compass today.