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Ask the Advisor: Why Index Funds?

By Guest Blogger(view all posts by Kent_Thune)
at 10:19AM Thursday August 19, 2010
under Personal Finance

Question: What is it that makes Index Funds a good investment?

The best way to explain Index Funds and their fundamental advantage over other types of mutual funds is to give a brief history:
Jack Bogle, the founder and retired CEO of Vanguard funds, created the first Index Fund, the First Index Investment Trust, on December 31, 1975. The fund was based on the ideas he put forth in his 1951 Princeton senior thesis paper, titled "Mutual Funds can make no claims to superiority over the Market Averages." This research paper revealed that most mutual fund managers fail to outperform the market averages over long periods of time.

If You Can't Beat 'em, Join 'em

Young Jack Bogle theorized that a mutual fund that simply invests in the securities within an index, such as the S&P 500, can keep management expenses extremely low, and therefore have an advantage over other funds that actively try to beat the market. In other words, the expenses required to research, select and monitor stocks for the conventional mutual fund decreases the net return of the investor, thereby reducing long-term returns. By having the choice of simply investing in the market in a passive, inexpensive way (Index Funds), an amateur investor can do as well or better than many of those mutual funds and managers that seek to beat the market.

Index Funds Still Winning Today

Morningstar, which is a company that specializes in researching and reporting on mutual funds, recently stated that low expenses are a greater predictor of superior fund performance than the star rating that made Morningstar famous in the investment world.

Today there are thousands of Index Funds to choose from but the fundamental advantage tying them together is low expenses. For example, according to Morningstar, the investor shares of the Vanguard 500 Index (VFINX) fund have an expense ratio of 0.18, while the average Large Blend mutual fund's expenses are 1.30%. This gives the index investor an average of an immediate 1.12% advantage!

According to Morningstar, over the past 15 years, as of June 30, 2010, VFINX outperforms 67% of all other Large Blend mutual funds.

Somewhere, Jack Bogle is smiling.

Kent Thune is a Certified Financial Plannerâ„¢ and owner of an independent, "fee-only" investment management firm in Mount Pleasant, SC. Kent is also a freelance writer. To read more of his work or to find out how to contact Kent, please visit his blog at The Financial Philosopher. Have a question? Email AsktheAdvisor@savings.com.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.