What are Index Funds?
Historically, financial advisors and brokerage firms have used mutual funds to gain exposure to particular asset classes. Mutual funds are convenient. They are easy to choose from and use a well-understood rating system offered by Morningstar. However, many advisors receive an annual commission from mutual fund companies, called a “12b-1” fee. And most mutual funds are actively managed, meaning fund managers attempt to pick individual securities that they believe will outperform a benchmark, usually an index.
Over the years, a significant amount of research has shown that between 80% and 90% of actively-managed mutual funds underperform the market—despite the fact that fund managers are being paid to do just the opposite. In 2010, Morningstar admitted that its rating system does not successfully identify mutual funds that will outperform the market in the future.
As a result, the passive “index” fund was developed. An index fund holds stocks in all of the companies within an overall market, as defined by that index. Some of the most popular indexes are the S&P 500 (which tracks large U.S. public companies), the Russell 2000 (small U.S. public companies), and the MSCI EAFE (tracking the largest companies in developed foreign countries). When one invests in an index fund, rather than trying to select a few securities that will “beat” the index, the investor receives nearly the exact return of the total market as represented by that index.
