5 Reasons We Love Index Funds

By Galia Gichon Monday October 12, 2009


Galia Gichon is the founder of Down-To-Earth Finance.

An index fund is a mutual fund that duplicates as closely as possible the performance of a particular stock market or bond benchmark, such as the S&P 500, the Nasdaq 100, the Dow Jones Industrial Average or the Barclays Bond Index. So why would someone with money to invest buy into an index fund? Here are a few reasons:

1. Lower fees and expenses. Because index mutual funds are passively managed, they charge lower fees and have some of the lowest expense ratios in the mutual fund market – as low as 0.19% (offered at some Vanguard funds) versus the market average of 1.50%. So if you have $10,000 invested, you’ll pay $19 a year in fees at an index fund versus $150 at a mutual fund. Hmmm…
   
   
2. Better performance. Most non-index funds don’t outperform their relative index, and only 35% of active fund managers beat their index, according to investment consulting firm Ibbotson Associates. So the question becomes: Why not go directly to the index?
   
   
3. Tax efficiency. For your taxable investments, you could have much lower capital gains tax due to less stock turnover – index funds don’t trade with the same frequency as mutual funds. And that will save you money on your taxes. Mutual funds with a high turnover ratio are hit with higher capital gains taxes in an up market, even if you didn’t sell your mutual fund shares.
   
   
4. Less stress. It’s usually easier to monitor index funds and their performance. If you invest in an S&P 500 index fund, for instance, you can easily check its Year-to-Date performance by looking it up on money.com, msnmoney.com or in your local paper. So much easier than reading statements!
   
   
5. Great performance comparison tools. Even if you don’t invest in an index fund, you can compare your mutual fund’s performance to the performance of its comparative index fund. For example, if you own a large-blend mutual fund, see how it performed relative to the S&P 500 index. Just go to Morningstar.com and look up your mutual fund. Find the performance table. Right under the fund’s actual performance, there’s a line that compares the performance to its index.

We don’t expect everyone to be as wild about index funds as we are. One argument against them is that their occasionally average performance. While that may be true, the dollars you save by not paying high mutual fund fees can, over time, make a huge difference. More cash in hand means more for you to invest and grow.