ETF Investing Guide: Why Indexing Wins

So you need to diversify. But buying individual stocks doesn't accomplish that, and actively managed mutual funds generally underperform the market. What do you do?

Answer: invest in index funds. Index funds are known as “passive” funds because they track established market indices or fixed baskets of stocks, in contrast to “active” funds that employ portfolio managers to actively pick stocks. In all cases, passive funds tend to be far more cost efficient than active funds because:

1. they have lower fees as they don’t need to pay portfolio managers to pick stocks (they don’t need to pay for active managers);
2. they have lower turnover in their portfolios, and therefore lower trading costs, since the compositions of the market indexes that they track do not change much over time; and
3. they are more tax efficient because lower portfolio turnover means fewer realized capital gains.

The largest index funds track the S&P 500, a group of 500 of the largest publicly traded US companies selected by a committee independent of the index funds that buy the stocks. Other indexes are available that cover the largest companies based on more objective criteria (without committee selection), and in some cases are broader-based (such as the Russell 1000 index).

If you buy an S&P 500 or Russell 1000 index fund, you can be confident that you can hold it for 20 years without the constituent companies losing competitiveness, since these indexes are periodically updated to represent only successful companies (defined by market capitalization). Since they represent the largest US companies, stocks are dropped from these indexes when the companies they represent shrink. As a result, sale of a stock by these index funds rarely results in realization of capital gains.

A key advantage of index funds is that you know exactly what’s in them, so you can avoid overlap between stock funds. Also, index funds should stay 100% invested in stocks, unlike actively managed mutual funds that have variable cash positions depending on the manager’s market expectations. So index funds allow you to allocate your assets effectively, the next topic we’ll discuss.

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