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Question:


What are index funds? I’ve heard that they’re diverse and safe[r] for novice investors like me.
-ReginaQ


Answer:


An index fund seeks to match the returns of a widely followed stock index such as the Standard & Poor’s 500, which is the one that many professional investors, including mutual fund managers, use as a benchmark against which their performance is judged. Funds that track broadly diversified stock indexes are as diverse as the indexes themselves. Whether they are as safe as or safer than actively managed stock funds – where the people in charge use their judgment to pick stocks and try to beat the market, not just match it – is debatable.
 
An S&P 500 index fund will be as safe as the S&P 500, with nearly identical ups and downs. A fund whose managers have latitude to fill it as they see fit can be more or less risky. If they select stocks of companies with consistent earnings growth, strong balance sheets and high dividend yields, their fund is likely to be safer, but if they focus on hot tech stocks or commodity plays that endure far more violent swings, the fund probably will be less safe and more volatile.
 
Where index funds do have most actively managed funds beat is in performance. That may seem odd – how can something designed to be average be better than average? The reason is that index funds are very cheap to run. With no high-priced managers making decisions, little to pay for research and almost no trading, total annual expenses can run as low as 0.1 percent of an index fund’s assets. A typical actively managed stock portfolio will have expenses of 1 percent to 1.5 percent. Over the very long haul, say 10 years, index funds will beat a great majority of actively managed funds with the same investment objective. So unless you have very good reasons for thinking that an actively managed fund will outperform – and the fact that it focuses on something that has been hot for a while, like gold, is not one of those reasons – then you are probably better off in an index fund.
-Conrad de Aenlle



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