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Quick Summary

  • Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
  • Warren Buffet is a big fan of index funds for individual investors, because of their low fees and their tendency to buy and hold positions.
  • Other benefits of index funds include tax advantages (they generate less taxable income) and low risk (since they’re highly diversified).
  • Index funds, over the long term, have outperformed other sorts of mutual funds.

With a net worth of nearly $79 billion, Warren Buffett is one of the greatest and most successful investors of all time. His investing style, which is based on discipline, value, and patience, has consistently yielded results that have outperformed the market for decades. While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow his one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.

As Buffett wrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.

What Is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as BlackRock or Vanguard.

The Benefits of Index Funds

Here are four key benefits that index funds offer.

1. Low Cost

A key benefit is that index funds have lower management fees than other mutual funds. That’s because, unlike most mutual funds, index funds are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index. Index funds hold investments until the index itself changes (which doesn’t happen very often), so they can offer lower management and transaction costs. Those lower fees can make a huge difference when it comes to your returns, especially over the long haul.

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

2. Tax Efficiency

Index funds by their nature offer several tax advantages, for a few different reasons. As index funds replicate the holdings of a specific index, they don’t trade in and out of securities as frequently as an actively managed fund would, so they generate less taxable income.

Also, index funds have to buy new lots of securities in the index whenever investors put money into the fund. As a result, an index fund may have hundreds or thousands of lots to choose from when selling a particular security, which means fund managers can sell the lots with the lowest tax bite (that is, they’ve registered less of a capital gain).

3. Lower Risk Through Broader Diversification

When you buy an index fund, you get a diversified selection of securities in one low-cost, easy investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broader diversification.

While each index fund offers exposure to a wide array of securities, you may have to invest in two or more index funds to get the exposure that’s right for you. For example, you could buy one equity index fund and one investment-grade bond index fund, keeping your ideal asset allocation in mind.

4. Proven Performance

Index funds have consistently beaten other types of funds. Buffet is such a fan of index funds that he once made a $500,000 “charitable wager” that an S&P 500 index fund would outperform a basket of five “funds of funds” chosen by hedge fund manager Ted Seides over the course of 10 years. After nine years the S&P 500 index fund had a total return of 85.4%, compared with only 22% for the hedge funds. Seides conceded the bet early.

 

The Drawbacks of Index Funds

No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming, and adjust or even liquidate the portfolio’s positions to buffer.

It’s easy to fuss about actively managed funds’ fees. But sometimes funds are justified in charging the big bucks—the expertise of a good investment manager can not only protect a portfolio, as described above, but even outperform the market.

Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.