The Benefits of Index Funds

It is clear that managed funds offer greater diversification than most people can achieve through direct share investing. Whilst there are many thousands of managed funds they can essentially be broken down to two groups, “active” and “passive”.

Active managed funds attempt to outperform the benchmark index through wise stock selection whilst ‘passive’ managed funds simply try to match the benchmark index. It is for this reason that passive funds are known as index funds. Index funds will hold every security in any given index, in the same percentage that the share is represented in the index. For example if share Y represents 3% of an index, then an index fund will have 3% of their funds invested in share Y.

Some investors shy away from index funds because they are not happy with the ‘average’ as a return; however they usually change their opinion when they are made aware of the advantages of index funds.

  1. Lower costs – An index fund does not incur research costs, or the high salaries and bonuses that are paid to some active fund managers. This is most index funds are approximately 0.50% cheaper than active managed funds.
  2. Tax Efficiencies-Stocks tend to stay in an index for a very long time, meaning that index funds will also hold stocks for a very long time. If you buy a stock but don’t sell it, you never incur a capital gains tax liability. Compare this with an active fund manager whose main objective is to have as high a headline rate as possible in order to attract new funds. Little concern is placed on the investor’s tax situation, and it is not unusual to see active funds turnover 100% of its portfolio every year. This can sometimes lead to the farcical situation where the investor has a negative return on their investment but still gets a tax bill.
  3. Diversification – As index funds invest in all or most of the shares in an index they provide a greater level of diversification then active fund managers. This increased diversification allows an investor to reduce risk, specifically unsystematic risk. This is one of the few times where you can reduce risk without sacrificing the return.

There is obviously always an average return for the share market, regardless of investment styles, and those who outperform the average return have done so at the expense of those who have underperformed the average return. Therefore we know that, before costs, the return of the average actively managed fund will generally equal the return of the share market on the whole, and thus the average index fund. As index funds have lower fees it must be a certainty that after fees the average index fund will always outperform the average active fund.

This is why an investor in index funds can be pretty sure they will outperform the average active fund managers, after costs, and never underperform the average active fund manager. And this is before tax is taken into consideration.

Share markets move in cycles, and in bull markets managed funds with a growth slant do better, but in bear markets value funds usually outperform. Whilst in any given year some active fund managers will outperform index funds, it is very rare for this performance to be continued in subsequent years. In fact only about 14% of the top 100 active fund managers in any one year period between 1996 and 2006 repeated their performance in the second year. Whilst every fund manager does indeed think they can beat the index, the fact is that every year about 50% of them don’t.

Because we are all looking to increase our wealth, we may as well seek the advice of the person considered to be the world’s best investor. I shall therefore leave the last words to Warren Buffett –

“Most investors, both institutional and individual, will find that the best way to own common stocks (“shares”) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.”

Warren Buffett, Berkshire Hathaway letter to shareholders 1996

“I believe that 98 or 99 percent – maybe more than 99 percent – of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs… Wall Street makes its money on activity. You make your money on inactivity.”

Warren Buffett, addressing MBA students at the University of Florida in 1998

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