Index Funds Explained: Why Costs Decide Almost Everything

An index fund owns everything in a list.

That is genuinely the whole idea. Someone maintains a list of companies — the S&P 500 is the familiar one — and the fund buys all of them, in proportion, and then does nothing.

No analyst deciding which companies look promising. No manager trading in and out. The fund holds what the list holds, and changes only when the list does.

It sounds almost lazy. It has also, over long periods, beaten most of the people being paid to do the opposite.

The Alternative, and What It Costs

An actively managed fund employs people to select investments. They research companies, form views, and buy and sell accordingly, aiming to beat the market.

All of that costs money, and the money comes out of your returns before you see them.

Two layers. The expense ratio is the annual management charge, deducted automatically. And trading costs — every purchase and sale carries a cost, so a fund that trades heavily incurs more.

Jason Zweig’s analysis in his commentary on Benjamin Graham illustrates the gap. A low-cost index fund might carry operating expenses around 0.2 percent and trading costs near 0.1 percent. A typical active fund of the era ran roughly 1.5 percent in expenses and about 2 percent in trading costs.

Assume the market returns 7 percent annually over twenty years. The index fund delivers just under 6.7 percent. The average active fund, after its costs, would be fortunate to reach 3.5 percent.

On $10,000, that is the difference between roughly $36,000 and just under $20,000.

Same market. Same period. The gap is almost entirely cost.

How Often Active Funds Actually Win

The honest answer is: over short periods, often enough. Over long periods, rarely.

Lipper data as of the end of 2002 looked at how many US stock funds had beaten the Vanguard 500 Index Fund across different periods. Over one year, roughly half. Over ten years, about 31 percent. Over twenty years, 37 out of 248 funds — under 15 percent.

The pattern held in earlier research too. A study tracking 1977 to 1997 found the share of equity mutual funds beating the S&P 500 falling from around half in the early years to barely a quarter by the end.

Those figures are historical, and worth stating as such. But the pattern has been remarkably persistent — subsequent long-running studies of active fund performance have found much the same thing.

And the real picture is worse than the numbers suggest. Databases like this typically exclude funds that closed or merged during the period, and funds usually close because they performed badly. Their absence flatters the survivors.

Why Even Good Managers Struggle

The difficulty is structural rather than a matter of talent.

Every trade has someone on the other side of it. For one manager to beat the market, another participant must underperform by the same amount. Collectively, active managers cannot all be above average — they are a large part of the market.

Then costs are subtracted. Which means the average actively managed dollar must trail the market by roughly the amount it costs to manage.

There is a behavioral layer too. Fund managers face career pressure to avoid looking wrong, which pushes them toward owning what everyone else owns. Finance researchers call this herding. Protecting their own position compromises their ability to do something different enough to outperform.

The Case Against the Consensus

This is where most articles stop. It is worth going further, because the argument is not entirely one-sided.

Sébastien Page of T. Rowe Price makes the point that “active managers underperform on average” is a statement about averages, and not every manager is average. Skilled managers with a disciplined repeatable process, real resources, reasonable fees, and a long time horizon have delivered excess returns over decades.

He also raises a more interesting argument: as more money flows into index funds, index investors buy and sell without regard to individual company merits. That can push prices away from what a company is actually worth — potentially creating opportunities for those still paying attention.

Worth weighing honestly. Also worth noting that Page works for an active manager, so he is not a disinterested party.

The practical difficulty remains: identifying a skilled manager in advance. Past performance identifies who has done well, which is not the same as who will. Distinguishing skill from luck requires far more data than most investors will ever have, a problem we touched on in why smart people make bad money decisions.

Which is why the conclusion holds for most people even granting the objection. Skilled managers exist. Reliably picking them beforehand is the part nobody has solved.

What Buffett Says

There is a certain irony here.

Warren Buffett built his career selecting individual companies. Yet he has advised for decades that most investors — institutional and individual — are best served by an index fund charging minimal fees, and that those doing so will beat the results delivered by the great majority of investment professionals.

Benjamin Graham reached the same conclusion late in his life, having spent his career teaching security analysis.

Neither says analysis is impossible. They say it is difficult, that most people attempting it will not succeed, and that the honest response is to stop trying — a distinction that follows directly from investing versus speculating.

What to Look At

If you decide indexing suits you, four things matter.

The expense ratio. The single most important number. Broad index funds are widely available in the low single digits of basis points. Anything approaching one percent for an index fund is not competitive.

What it tracks. A total US stock market fund and an S&P 500 fund are both broad. A fund tracking a single sector or theme is not — it is a concentrated bet wearing an index fund’s clothing.

ETF or mutual fund. Both work. ETFs trade like stocks during market hours; mutual funds price once daily. For someone contributing monthly and leaving it alone, the difference is minor.

What is in your 401(k). Workplace plans vary enormously. If yours offers no low-cost index option, that is worth raising with your employer — plan sponsors do respond to employee interest, and it affects everyone in the plan.

The One Real Drawback

Zweig put it well: index funds are boring.

You will never beat the market, because matching it is the entire design. You will never have a story about the fund you spotted early. You will hold everything, including the companies doing badly.

For anyone who finds investing interesting, that is genuinely unsatisfying. It is also, over twenty years of monthly contributions, likely to leave you ahead of most professionals and nearly all individuals.

If you want the interesting version, the advice from article one applies: keep it in a separate account and keep it small.

Before Any of This

Index funds are a tool for money you can leave alone for years.

Which means the sequence still applies. Emergency fund first. High-interest debt cleared. Employer match captured. Then investing, as set out in how much you should save each month and which retirement accounts to fill first.

An index fund cannot help you if you have to sell it in eighteen months to cover a car repair.

The Bottom Line

An index fund buys everything on a list and holds it. Its advantage is not clever selection — it is the absence of the costs that come with clever selection.

Over long periods, that cost advantage compounds into a gap most active management does not close.

Skilled active managers exist. Identifying them in advance is the unsolved part, which is why the people best qualified to pick stocks tend to recommend that you do not.

Check the expense ratio. Choose something broad. Contribute regularly. Then leave it alone.

This article is general information, not personalized investment advice. All investing involves risk, including possible loss of principal.

Browse our other topics on the Explore BlurbMoney page.