" The average actively managed mutual fund costs eight times more than the average index fund"
-Investment Company Institute 2017 Fact Book
What is indexing?
Indexing as an investment strategy has gained tremendous popularity since its beginnings in the early 1970s.
Indexing is an investment approach that seeks to track the performance of a specific benchmark, or index. Index funds do this by holding all (or a representative sample) of the securities in the index being tracked. This "passive" investment approach emphasizes broad diversification, limited trading of the securities held in the portfolio, and low costs.
By contrast, actively managed funds aim to outperform a benchmark index. Of course, all active managers experience times when their investing style is out of favor, but over a reasonably long period—covering multiple market cycles and environments—a skilled active manager should, in theory, be able to deliver positive excess returns versus a relevant benchmark index. But, in practice, the track record of actively managed funds has been underwhelming, suggesting that such skill is difficult to find*.
The benefits of indexing
Diversification Maintaining a well-diversified portfolio is an essential part of a successful investment plan. Indexing can be an ideal way to achieve diversification.
Low cost Index funds have a powerful advantage over actively managed funds - lower costs. It simply costs less to manage and operate an index fund. Index funds don't have to employ highly paid fund managers and their staffs to analyze and select stocks.
Competitive performance Thanks to their diversification and low costs, index funds can be an effective way to achieve competitive returns over the long run.
Potential for tax efficiency Index funds typically have much lower portfolio turnover than actively managed funds. Therefore, most index funds tend to realize and distribute only modest capital gains. This is particularly important if you hold index funds in taxable accounts.
Simplicity There's nothing complicated about how index funds are designed or how they operate. They have a precise, easily understood objective - to track the performance of a specific index. With index funds, you always know how your money is invested.
There are number of ways how index funds can be used as part of your investment program. As we're building a well diversified balanced portfolio, index funds provide exposure to domestic or international markets, small-cap or large-cap stocks, bonds or a specific sector.