What The Heck Is An Index Fund?
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What The Heck Is An Index Fund?

From an early age, we’re taught to celebrate
winners. Look up to champions. Revere Gold-medalists. We make fun of “participation trophies”. I mean, when was the last time you heard somebody
bragging about having a few dozen followers or a perfectly average salary? So how do you explain the explosion in popularity
in an investment tool that offers nothing more than a guarantee of average results? Nothing fancy… just average. Strange as it might seem at first glance,
the meteoric rise of the “Index Fund” is a lesson in how sometimes, aiming for “average”
might be the “best” strategy of all. In an earlier episode, we explained how mutual
funds offer numerous benefits — like low share prices, broad diversification, convenience,
and ease. Their debut in 1924 ushered in a golden age
for active portfolio managers. Professional investment management was suddenly
no longer just for the ultra-wealthy. The American middle class poured their savings
and retirement accounts into mutual funds with abandon. Today, with nearly 10,000 mutual funds available,
it can look like a Cheesecake Factory menu, endlessly long and complicated. So most fund managers compete to deliver the
maximum amount of “alpha”. That’s just investor-speak for how much
BETTER the portfolio manager did than the market average. The way managers measure their success is
by comparing their returns to an “index”. An index is a hypothetical portfolio that
represents a segment of a financial market. For example, the S&P 500 index measures the
average stock gains or losses of the 500 largest companies in the US. There are indices for virtually every type
of investment all across the world: precious metals, oil, bonds, even a pork carcass index. Their main use is as a comparison tool. For a long time, trying to “beat the index”
with your mutual fund made sense to most investors. I mean, who would want to put their money
with a fund manager who charged expensive fees but failed to beat the market most of
the time? But then, a dirty little secret was uncovered. Most professional fund managers consistently
fail to meet-or-beat their index by a wide margin. One study found that, 90% of active-fund managers
did worse than their relative index. And these are supposed to be the best of the
best with Ivy league educations, decades of experience and sophisticated trading tools. There are a few factors that make it difficult
for fund managers to “beat the market”. The first is fees. Actively managed mutual funds employ teams
of researchers, analysts, and traders. That costs money. And you, the investor, end up paying for it. Actively managed funds have annual fees on
average of around 1.4%. In other words, your mutual fund has to make
1.4% per year just to keep you from LOSING money! A second key factor is that humans are really
really bad at telling the future. In the 1973 book, “A Random Walk Down Wall-street”,
Burton Milkier suggested that investment markets are too complicated and, well, random, to
be consistently predicted. Researchers found that you’d do just as
well picking stocks blindfolded as you would giving your money to a portfolio manager. No seriously, in a contest run by the UK Observer,
professional portfolio managers tested their skills against the stock-picking prowess of
a cat named Orlando. Orlando shredded the pro’s. Milkier suggested the creation of a new, low-cost
mutual fund that simply buys the hundreds of stocks within the index, and doesn’t
jump from stock to stock, trying to beat the market. That sounded like a great idea to a guy named
John Bogle. In 1975, he launched Vanguard’s “First
Index Investment Trust”. No more promises of beating the market — the
only guarantee was that your investments would do slightly worse than average (since even
index funds have minimal fees). Sound a little… underwhelming? Yeah, it did to investors at the time too. The fund was ignored – or outright mocked
– for years, and many thought it wouldn’t survive. Spoiler Alert: it did. Over the last half-century, more and more
investor’s started wising up and today Index Funds and Index ETFs are more popular than
ever with nearly 7 trillion dollars resting in index-type funds. It seems the promise of consistently “average”
results doesn’t sound so shabby to investors any more. This is also thanks to the investing Godfather…Warren
Buffet. In 2007 he made a million dollar bet with
the world’s best hedge-fund managers that they couldn’t out-perform an S&P 500 Index
Fund over a 10 year period. And wouldn’t you know it, despite weathering
the 08 crash, the index fund trounced the hedge funds, averaging an annual 7.2% return,
compared to the hedge funds measly 2.2%. Now, to be clear, index funds are not the
“perfect investment.’’ There is no such thing. But Warren Buffett famously quipped that Index-Fund
investing is the best move for 99% of investors out there. So if you decide to join the club, start simple
and don’t forget to diversify! For example, a basic blend of three broad
indices would allow you to diversify into a huge spread of countries, companies, and
asset types. Index funds are available through most fund-companies
and can be bought within a retirement account like an IRA or 401k. And unless you’re a seasoned investor, speaking
to a professional to set an ideal blend is a smart step. There are also online “robe-advisor” services
that can automatically make the blend for you, based on your goals and risk tolerance. So next time your momma asks if you’re doing
your best, say… actually Warren Buffet says that I should just strive to be average! She’ll be thrilled. And that’s our two cents! Hey guys! It’s Philip and Julia again. Question: How can you make your favorite meals even more delicious? Add a dash of science of course. Serving Up Science is a PBS Digital Studios show hosted by history buff, science writer and foodie Sheril Kirshenbaum who is serving us science backed answers to all of our biggest food questions such as: Should you let your meat rest? What’s better, wild of farmed salmon? What makes blue cheese so stinky? Ah! I think you mean delicious. So, head on over to Serving Up Science and tell them Two Cents sent you. We’ll be nerding out right along with you. What else would you like to know about Index
funds? Ask your questions in the comments section.


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