What Is an Index Fund and Why Do Most Experts Recommend Them?

An index fund is a type of investment fund designed to track the performance of a specific market index — such as the S&P 500, which represents 500 of the largest publicly traded US companies. Rather than having a fund manager actively selecting which stocks to buy and sell the index fund simply holds all the stocks in the index in proportion to their size. The result is a fund that automatically mirrors the performance of the overall market or market segment it tracks at very low cost.

How Index Funds Work

When you invest in an S&P 500 index fund you effectively own a tiny piece of all 500 companies in the index. When those companies as a whole perform well your investment grows. When they perform poorly your investment declines. You do not benefit from any single stock picking genius and you do not suffer from any single stock picking mistake. Your returns are the returns of the broad market — which historically have averaged approximately 7 to 10 percent per year over long periods depending on the time frame measured.

Why the Low Cost Matters So Much

The expense ratio — the annual fee charged by a fund as a percentage of assets — is where index funds dramatically outperform actively managed alternatives. A typical actively managed mutual fund charges 0.5 to 1.5 percent annually. A typical S&P 500 index fund charges 0.03 to 0.10 percent — often 10 to 50 times less. This difference compounds dramatically over decades. On a $100,000 investment over 30 years the difference between a 1 percent fee and a 0.05 percent fee is approximately $200,000 in lost returns — money that went to the fund company rather than staying in your account compounding for your retirement.

Why Active Managers Consistently Underperform

The persistent and uncomfortable finding in investment research is that the majority of actively managed funds underperform their benchmark index over periods of 10 years or longer — typically 80 to 90 percent of active funds fail to beat the index over long periods after fees. This is not because fund managers are incompetent. It is because markets are efficient — prices already reflect available information — and because the fees active funds charge represent a structural disadvantage that most managers cannot overcome regardless of skill.

Index Funds and the Bi-Weekly Investor

Index funds combined with automatic bi-weekly contributions create one of the most powerful wealth building setups available to ordinary investors. Each paycheck a fixed amount goes into a low-cost index fund. Dollar cost averaging happens automatically. Fees are minimal. Diversification is instant across hundreds of companies. No ongoing decisions are required. This set-it-and-forget-it approach has outperformed the active stock picking of most professional investors over most measured time periods in history.