In the 1978 suspense novel, ‘Killing Mr. Griffin,’ Author Lois Duncan remarked:
“The best things in life are simple. Simple things work. They don't foul up. It's the complicated things that get twisted around on you.”
There’s an inherent beauty in simplicity.
Enter index funds, a type of investment fund that seeks to replicate the performance of a specific market index. Since the creation of the first index fund by Vanguard in 1976 to March 2022, the index fund market has grown to $8.53 trillion.
Therefore, today we’ll be examining two features in particular that make index funds a simple yet highly effective method of investing.
Index Funds Are Cost Efficient
One of the fundamental pillars of building wealth is maximizing returns in the most cost-efficient manner possible.
And index funds do this extraordinarily well.
Unlike their actively managed counterparts, which often incur higher fees due to the need for professional fund managers, index funds operate on a passive investment strategy.
This passive stance leads to reduced expense ratios, representing the percentage of a fund's assets allocated to cover its operating costs, ultimately shouldered by its investors.
This financially prudent approach ensures that a substantial portion of an investor's returns remains unburdened by fees, facilitating more efficient wealth growth over time.
Or said another way:
Lower Expense Ratio = Lower Fees = More Money In Our Pocket
However, I like numbers. So, let’s consider the following:
Let’s assume we have an active fund that earns 10% YoY and a passive index fund that also earns 10% YoY. The active fund’s expense ratio is 0.75% while the passive fund’s expense ratio is 0.04%.
How would a one-time investment of $10,000 in each fund fair after 30 years?
Due to its lower expense ratio, the passive index fund yielded an additional $30,484.33.
Much like returns, fees also compound over time.
Some would argue that actively managed funds can produce superior returns that make up for the higher fee, and while it’s not impossible to outperform the market, it is rarely done with any consistency.
Index Funds Provide Instant & Automated Diversification
In the Real Estate Industry, there is the phrase “Location, Location, Location.”
When it comes to investing and risk management, it’s all about “Diversification, Diversification, Diversification.”
By their very nature, index funds can offer instant diversification across a broad spectrum of assets. By tracking entire market indices, index funds inherently spread risk and exposure, reducing vulnerability to the fluctuations of individual stocks.
This diversification not only cushions against market volatility but also provides a safeguard against the potential downfall of any single company.
By the same token, index funds are also considered self-pruning.
In other words, if an individual stock is removed from or added to a certain index, that will then be reflected in the index fund. This is done without any intervention on our part.
Contrast this with the individuals who are meticulously hand-picking individual securities in order to create a robust and diversified portfolio.
Employing this approach can indeed result in a comparable diversification effect, but also involves heightened frictional costs (both time and money) for the individual. These expenses stem directly from the manual efforts needed to consistently uphold an optimal level of portfolio diversification.
Final Thoughts
There’s a certain unparalleled beauty in regards to the convenience and efficiency that index fund investing offers.
The reality is that consistently beating the market is incredibly difficult. Therefore, if you can’t beat the market, join it!
Disclaimer: Nothing in this article should ever be considered advice, research or an invitation to buy or sell securities. I am not a financial advisor.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
