Popular investing wisdom holds that index funds generally perform as well as the market and have lower expenses than traditional mutual funds – but is that true?
An index fund seeks to match the returns of a specific index by holding all – or in the case of very large indices, a representative sample – of its securities.
Since the stocks in an index change infrequently, the stocks in the index fund also change infrequently.
Why do people use index funds?
For the past 50 years ending on December 31, 2008, the U.S. stock market, as represented by the S&P 500 Index, provided investors with an average return of 9.19% per year.
Some investors earned more than 9.19%, while others didn’t fare as well.
So some investors figure that it’s better to imitate the index – and hopefully obtain similar returns – than it is to try to beat the index.
The downside to index funds, however, is that they perform similarly to the market not just when the market is up but also when the market is on a downswing.
They can also underperform the market due to expenses and the percentage of their portfolios held in cash.
For some investors, index funds may be a good choice.
They often have lower expense ratios and less portfolio turnover – and thus fewer capital gains taxes – than do traditional actively managed funds.
And because they imitate the market, they usually perform similarly to it.
One thing to keep in mind, though, is that past performance is no guarantee of future results.
Index returns assume reinvestment of all distributions and do not reflect any fees or expenses.
What type of fund is best for you?
The best course of action is to consult a financial advisor who is familiar with your circumstances and goals and who can give you more personal guidance.