“Building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic.”

– Bethany McLean, “The Skeptic’s Guide to Mutual Funds,” Fortune, March 15, 1999

An amusing comment attributed to ‘Anonymous’ captures the perils of “active” investing: “I own last year’s top performing funds. Unfortunately, I bought them this year.” As the caveat in small print always reads, in some variation of this wording, “Past results are not necessarily indicative of future results.”

Over time, the stock market has provided returns of 9% per year but the average investor’s experience does not reflect this rosy outcome. Mutual fund management fees consume on average 2% of these returns, while other costs coupled with investor behaviour – buying high and selling low, or exiting the stock market when one should stay the course and reap the returns of the rebound – erodes even more of these returns. How can investors keep more of what their investments earn?

Enter Index Funds

Index funds have a history stretching back to 1960, when a paper by two academics1) at the University of California noted that many mutual funds were not outperforming the Dow Jones Industrial Average. To further aggravate the situation, investors were paying high fees for this lacklustre performance. In an argument presaging the development of index funds, the authors reasoned that investors would be better off targeting average returns rather than trying to select a winning fund manager, which most people lack the expertise to do. Moreover, investors in an “unmanaged fund” would sharply reduce costs associated with actively managed funds, positively affecting their returns.

Initially, the obstacle to implementing these ideas was the difficulty and expense of tracking an index in real time. In the early 1970’s, funds that sampled the index, such as the Standard & Poor’s 500, were developed and adopted by institutional advisors. Individual investors had to wait until the summer of 1976, when John Bogle rolled out Vanguard’s index fund. At the time it was derided as his “folly”, but has now become the highly regarded Vanguard 500 Index Fund with about $260 billion under management.

What is an index fund and how does it work?

An index is a number which measures and tracks the value of a group of stocks. An index fund is a type of mutual fund which pools money from individual investors and buys fractional amounts of each of the securities the index tracks. In other words, an index fund follows or mirrors the movements of the market. This approach ensures a diversified portfolio of stocks, which is one of the hallmarks of successful investing. Index funds are designed to produce an average return, rather than attempting to outperform the market, so there is no need for expensive research or analysis. For this reason, they are said to be “passively managed” as opposed to the “active management” of fund managers who attempt to pick winning stocks and trends. Because the fund is managed largely by computers, which buy and sell stocks in the same proportion they exist in the index, index funds usually charge very small management fees.

Index funds have withstood the test of time

On March 1, 2015 the Wall Street Journal published the following chart (which uses data from Morningstar Inc.) showing twenty years of returns of actively managed versus passively managed US equity funds. Bear in mind that these returns are before costs have been deducted, and that costs for actively managed funds are much higher than for those passively managed.

1) Edward Renshaw, economist at University of California, with MBA student Paul Feldstein: “The Case for an Unmanaged Investment Company,” Financial Analysts Journal, 1960.