Index Funds and Index ETF’s – What and Why?

Warren Buffett – Arguably, the greatest investor of all time, in 2008, threw out an open challenge to the hedge fund industry that an S&P 500 index fund would beat any of their actively managed funds over a 10 year period. And in 2018, he won the $1 million bet. Warren’s own investing success stems from actively managing his investments however. So one may argue that him making this bet makes him a hypocrite. Or maybe someone who understands just how hard it is to replicate what he achieved.

Either way, the bottom line is that it is extremely difficult to beat the returns of the overall stock market over the long term. From my perspective, that is all investing since I believe investments should always be made for the long term. One should never ‘invest’ money they hope to use in 12 months.

Wall Street is littered with fund managers and analysts working night and day to try and beat the stock market. Few of them actually manage to do so and when they do, they get massive bonuses enabling them to buy their third home in the Hamptons to summer in. Most of our 401k dollars are managed by one of these fund managers that make independent decisions on how to deploy YOUR dollars and earn a commission from the returns they generate. These commissions are usually charged either as a percentage of returns, fixed management fees or both. The question is – if it is so difficult to beat the overall stock market, is it really worth paying these if they cannot even beat the overall market over the long term? And are there any alternatives?

What are Index Funds?

You may have heard of the Dow Jones Industrial Average or the S&P 500. These are respected stock market indexes that are representative of the large part of the US economy. The Dow Jones consists of 30 large companies from different sectors of the US economy. The S&P 500 is a collection of 500 of the largest publicly traded companies in the US. In essence, these indexes paint a picture of the US economy.

When companies in these indexes underperform, they are replaced by other strong performers from the outside and vice versa. So these indexes always carry the cream of the crop.

Index Funds are mutual funds structured to mirror the investment mix of their benchmark index. So an S&P 500 index fund will perform pretty much exactly as well (or as badly) as the S&P 500 index (in other words, the 500 companies therein).

Hence, this investment vehicle needs no human intervention and can pretty much be entirely automated, making it a passive investment. Since there isn’t a fund manager managing it, no bonuses for them to buy homes in the Hamptons. This results in very low management fees. The Vanguard 500 index fund has an expense ratio of 0.04%. That means you pay 4 cents for every $1000 you invest and you get the returns that Warren Buffett bets, will beat any fund manager over the long run. Why an average person buys actively managed funds is beyond me.

Believe it or not, index funds are actually already dated. You can now buy something called an S&P 500 ‘Exchange Traded Fund’.

What are Index Exchange Traded Funds?

While index funds were a pool of money so invested to mimic the mix of an index, Index ETFs are all that then converted into a security (or stock) that actively trades on the market just like any other company’s stock. That means, you do not need a minimum investment to participate, you can instantly sell your investment to other investors and vice versa and get dividend disbursements just like other stocks. It is just a better version of the index fund and cheaper. The Vanguard 500 ETF (Ticker – VOO) has an expense ratio of 0.03%. You only pay 3 cents for every $1000 invested while gaining diversified exposure to some of the strongest companies in the country.

An actively managed fund on the other hand costs $7.10 on average for every $1000 invested. And remember, most of the time, they cannot even replicate the success of the index over the long run. Bizarre, I know.

There are a number of different S&P 500 ETFs from different companies and they charge different fees. SPY charges almost 3 times the fees of VOO but their claim to fame is popularity allowing more liquidity (easier to sell and buy). But unless you’re looking to buy and sell a million dollars in ETFs at a time, it should make no difference to you. Go for VOO and save some money.

The Final Verdict

In my humble opinion, index funds and index fund ETFs are a no brainer for anyone looking to invest long term. You won’t be paying a Wall St. billionaire get wealthier off of you for doing a lousier job than a computer algorithm making them a great equalizer. You don’t need to be a genius to invest. If you think the 500 biggest companies in America are going to do well in the long run, You can buy a piece of America’s future with as little as a couple hundred dollars.

To prove this point further, my own personal 401k dollars have been distributed across 3 different funds and over the last 3 years, the large cap index fund (WBRE0X) has outperformed the mid cap index fund (FSMDX) and more importantly, the actively managed fund (VEIRX) that charges 6 times the Expense Ratio of the passive funds. In essence, I paid an Wall St. fund manager exorbitant amounts of money to do worse than a computer. Case in point.

Note: I’ve used 3 years because the index fund in my 401k account has only been around since 2017.