Index funds are the epitome of passive investing.
Rather than trying to beat the market by selecting individual stocks, these funds own all stocks constituting the index, matching the performance of the underlying benchmark. There are plenty of advantages to this way of investing – lower fees, less reliance on the competence of a fund manager (many of whom fail to beat the market) and market-wide diversification make index funds one of the safest ways to invest your money.
The greatest advantage index funds have offered over the last few years is their ability to capture the returns of the longest bull run in stock market history. Over the last 10 years, the SPDR S&P 500 ETF Trust (ticker: SPY), an exchange-traded fund that mimics the S&P 500 index, has enjoyed an average annual return of 11.04% – not bad at all, and better than many individual investors have been able to achieve.
Investors have responded to the impressive performance of index funds by fleeing from actively managed funds in droves and putting their hard-earned money into passively managed funds. According to Morningstar, in 2019, investors withdrew a net total of $204.1 billion from actively managed U.S. stock funds, while passively managed funds saw investors pour in $162.7 billion. This was the culmination of a years-long trend, marking the first time in history that the total assets of passive funds surpassed those of active funds.
Then a global pandemic began.
While index funds may be the pinnacle of passive investing, 2020 has been anything but passive for the stock market.
Market volatility inherently favors stock pickers adept at changing with the times, while index funds have been left to hang on for dear life as the markets have surged and sagged. Tech stocks, like Facebook (FB), Amazon (AMZN) and others within the FAANG group, have dramatically outpaced the market, meaning that investors who focused their funds on these companies are beating the returns of their peers whose investments are diversified across an entire index.
In short, the volatility of 2020 has raised a potent, important question:
Are Index Funds Safe Investments?
Just because index funds have been volatile does not mean investors should necessarily steer clear, says Matthew Lui, vice president at Investment Research Canterbury Consulting. They should assess their risk tolerance in light of the drawdown and understand that even though investing in index funds has been smooth sailing for quite some time, every once in a while youll get whacked with an event like what happened in the first quarter.
Derek Horstmeyer, associate professor at George Mason University School of Business, agrees.
Index funds are still the best bet in this terrible roller-coaster environment. The single greatest factor in long-run returns for a fund are the fees paid, Horstmeyer says. With index funds now with expense ratios down at close to zero, this is still far better than any actively managed fund. Further, active management notoriously does poorly in volatile periods since they are bad market timers – this is another reason to stick with indexers.
As if the benefits dont end there, Horstmeyer goes on: Index funds are also far more tax efficient, which is very important in volatile markets to maximize after-tax returns.
But does sticking with index funds mean leaving potential gains on the table? After all, the recent upswing in the market has been the result of a surge in a few core industries, namely tech, while other sectors such as travel and hospitality have largely lagged. And while the diversification of index funds is one of their greatest strengths when the market as a whole is moving upward, if gains are piecemeal, then index funds may become eclipsed by the gains of actively managed funds.
Yet no less than Jack Bogle himself, the father of index investing, encouraged investors to focus less on the flashy gains and losses and more on the hidden costs of active investing. Namely, fees.
Active management can be an effective approach, Lui admits. Strong active managers can take advantage of short-term opportunities caused by big market moves to outperform index funds. However, our research has shown that it is difficult, though not impossible, to identify active managers that can consistently outperform net of fees.
This is particularly true in widely-trafficked areas such as large-cap U.S. stocks, he adds.
Fees are the hidden costs of actively managed funds that chip away at your profits. These fees usually take the form of management fees, operating expenses or expense ratios – a calculation of a mutual funds operating expenses divided by the average total dollar value of the assets in the fund. For actively managed funds, the expense ratio usually ranges from 0.5% to 1%, with 1.5% on the more expensive end. Although those numbers may sound low, they add up over time and eat deeply into any gains you see. Meanwhile, the expense ratio of passive index funds is often closer to 0.2%.
The Best Index Funds for You
If you believe in the markets turnaround and that things will continue to get better from here, whats the best index fund to invest in if youre bullish?
As a rule of thumb, index funds that focus on stocks of smaller, foreign, or more cyclical companies tend to be riskier but carry the prospect of potentially higher returns in the long run, says Lui. These may be suitable for investors with a higher risk tolerance and a more bullish outlook.
As for the bears, Lui notes that for the more defensive-minded, index funds that invest in large U.S. companies, such as the S&P 500, tend to be less volatile compared to the above options. Balanced funds (comprising a mix of stocks and bonds) can also be a way to provide downside protection.
So, at the end of the day, are index funds still a good idea right now?
Brandon Renfroe, financial advisor and assistant professor of finance at East Texas Baptist University, summarizes it well.
Index funds are still a good choice in 2020, but its important to remember why you would choose index funds in the first place. Index investing relies on a belief that you cant consistently select better individual investments. Successful index investing means you accept the market average, and get it in a cost-effective way.
Your personal investment horizon is also important to keep in mind. If you are only thinking about short-term return relative to other funds, youll always be able to find a reason to regret choosing index funds. Its the nature of the strategy, Renfroe adds.
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