Index funds are mutual funds that hold the same proportions of specific shares as the proportions of shares held by a specific benchmark or index. Exchange-traded funds (ETFs) are mutual funds similar to index funds, except that instead of only being traded once a day like a mutual fund, they can be purchased and sold at any time the market in which they trade is open, The goal of index funds and ETFs is to match the benchmark performance of a specific asset class. There are nearly one thousand different index funds and over 500 different ETFs, and they all follow different indices or benchmarks related to geography, maturity, capitalization, and style.

Index funds and ETFs were created because some investors were concerned that actively managed funds were not always able to beat benchmarks after the effects of fees, taxes, and other expenses. By purchasing an index fund, investors stop trying to beat the benchmark: instead, investors accept the benchmark’s return and risk. Interestingly, index funds have tended to outperform most actively managed mutual funds over the long-term.

ETFs were created because index funds only trade once per day at the fund’s ending net asset value.  Some wanted to trade index funds throughout the day.  In addition, although the management fees on index funds were low, some thought they should be even lower.  Hence, many ETFs have even lower management fees that many index funds.  However, since ETFs trade on a market just like a stock, investors in ETFs need to calculate the additional cost of buying and selling the shares into the total cost calculation.

Active management tends to hurt a mutual fund’s performance because excessive trading generates taxes and fees. Actively managed funds also have much higher management fees than index funds. (The average index fund charges eighteen basis points, while the average actively managed mutual fund charges eighty to two hundred basis points) Since history shows that it is unlikely that last year’s best-performing funds will be this year’s best-performing funds, investors have found it difficult to consistently choose actively managed mutual funds that are able to outperform index funds, especially after fees and taxes have been accounted for.

Index funds and ETFs use a passive investing strategy that requires very little time to maintain. Passive investment does not require you to know much about valuation, security analysis, or other company-specific information. You just need to be willing to accept the general market return for the asset classes included in your index fund or ETF. Although returns on index funds vary from year to year (just as returns on benchmarks vary from year to year), they still yield a consistent, respectable return. Jason Zweig, a senior writer for Money Magazine said the following about index funds:

With an index fund, you are on permanent auto-pilot: you will always get what the market is willing to give, no more and no less. By enabling me to say “I don't know, and I don't care,” my index fund has liberated me from the feeling that I need to forecast what the market is about to do. That gives me more time and mental energy for the important things in life, like playing with my kids and working in my garden. (Jason Zweig, “Indexing Lets You Say Those Magic Words,” CNN Money, August 29, 2001)

Index funds have become the standard against which other mutual funds are judged. If an actively managed mutual fund cannot perform better (after taxes and fees) than an index fund (index funds are very tax efficient), then investors should lean toward purchasing the index fund. Warren Buffet wrote the following in 1993. I believe his statement still applies today:

By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb. (Warren Buffett, Letter to Berkshire Hathaway Shareholders, 1993)

In addition, the amount of time necessary to invest in index funds and ETFs is significantly less than the time needed to analyze, evaluate, value, and purchase individual stocks. In general, most actively managed funds and brokerage accounts will generally under-perform index funds in the long run after all taxes, costs, and fees. Invest accordingly.

The competition in stock-market research is intense and will get more competitive going forward. This will help in making markets more efficient and indexing even more attractive. Market indexing or “passive investing” is a free-ride on the competition. It takes very little time and contributes to a “sleep-well” portfolio. In summary, many dislike indexing because passive investing is boring, picking stocks can be intellectually challenging, investment “war” stories are fun to share with friends, and doing “nothing” about your investments is unnerving. Reasons to index include immediate diversification, generally superior long-run performance, and a tax-efficient strategy, and it takes very little time, allowing you to spend more time on the things that are important to you.