Investing in Index Funds makes financial sense

Investing in Index Funds makes financial sense
21 July 2013

If your full time job is not an investment manager analyzing which stocks to invest your own money in to grow your wealth then it can be very confusing knowing how and where to invest 

Thankfully some investment managers have made it easier for us.

Passive versus active management funds

For the main part I far prefer active management of my own investments, but this is a skill set developed over many years of working in the finance sector. However when people who do not have the time to actively manage their portfolio ask me where they should invest their money, I always recommend Index Funds.

What are Index funds?

What an index fund does is simple: It invests in the entire index. For example, an S&P 500 index fund buys all the stocks in the S&P 500 index, or the Nasdaq-100 index fund buys shares in all companies in the Nasdaq-100. Thus spreading the risk and effectively tracking the market. Of course these funds will never ‘beat the market,’ but as many a wise investor knows it is very difficult to consistently beat the market.

When they were first introduced, index funds were controversial because they challenged the widely held assumption that most active fund managers could consistently outperform market averages. 

Reports indicate Index funds outperform the active funds

According to Standard and Poor’s 2012 report comparing index funds to their actively managed counterparts, index funds produced better returns than actively managed funds in 16 of 17 investment categories over the previous five years. This has also been reiterated and widely spoken about by Warren Buffett who said: “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” 

Index fees have lower costs

The reason has to do largely with costs. Because index funds don't need to employ legions of analysts and managers to decide what to buy and sell, they can operate more efficiently and it is therefore the investors in these index funds that benefit over time.

A conventional actively managed fund on average charges 2.5% of your money every year, while a high quality index fund should cost you just 0.2% a year.

Research from consumer group Which? shows that if you invested £10,000 (AED 56,000) in a fund with no charges, and it grew by 6% annually for 20 years, you'd get a return of £32,071 (AED 179,780) -- just over £22,000  (AED 123,326) growth. If you invested in a fund with fees totalling 2.5% a year, you'd be paying out £12,000  (AED 67,269) in charges, leaving you with a far lower return (and that is not including transaction costs).

The holy grail of investing is buy low and sell high, closely followed by the more you spend in costs, the less you get to keep.  Do you hold any of your investments or pension fund in Index Funds? Have you suffered due to the high cost of actively managed funds?

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Author
Head of Behavioral Finance
cashy
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