- 3-Minute Article
- Sep 23, 2019
A Closer Look at Index Funds
Reviewing the pros and cons of index funds can help advisors and clients find the best fit for their portfolios.
The shift from traditional “active” funds to “passive” index funds is one of the biggest investment trends in recent years. Investors added $156 billion to index funds in 2018, while continuing to pull money out of actively managed funds.1 Indexing is especially popular in U.S. stock funds. Over the past 10 years, passively managed domestic equity funds have attracted $1.6 trillion in new assets, while assets in active domestic equity funds have fallen by $1.4 trillion.2
Index funds appeal to many people because of their low costs and simplicity: It’s easy to understand a fund’s investment strategy and pay less for that investment due to the way index funds are managed. Widespread use of index funds as investment options in variable annuities and other financial products—along with insurance products that track index performance as a way to credit customer accounts in some insurance products—also contributes to that growth.
Yet there are thousands of options with varying degrees of risk to choose from when selecting mutual funds. To decide if index funds are a good fit for your financial plan, it’s important to understand the difference between active and passive funds and assess the pros and cons of each.
All mutual funds hold a mix of investments such as stocks or bonds, but index funds assemble their portfolios differently than active funds. Active managers research which investments to buy and sell, aiming to pick winners that will beat the market. The fund’s returns depend on the success or failure of these selections.
Index funds, on the other hand, don’t rely on analysts and managers to pick investments. Instead, they identify a market index to follow and then assemble a portfolio that matches the makeup of that index. For example, a fund based on the S&P 500® Index would hold every stock in the index, and its returns would closely follow the ups and downs of the index itself.
Comparing Active and Index Funds
The biggest advantage of index funds is their fees. Because there are no analysts researching investments and managers make fewer buying and selling decisions, index funds can charge lower expense ratios, the total annual fee that’s deducted from shareholder returns to offset operating costs, management and administrative fees, and other expenses. For example, the average expense ratio for actively managed stock funds is 0.76 percent, compared to just 0.08 percent for index stock funds.3
Another advantage of index funds is their potential for diversification. There are thousands of index funds, tracking a range of indices built to target specific types of stocks (such as large versus small), investment styles (value versus growth), and even individual sectors and geographic regions.
Index funds’ biggest limitation is that they will rarely outperform the market—by design, they can only rise as much as the market index it tracks. Index funds also provide no buffer from broad market downturns. They will fall the same amount as the market index does, unless the fund is held inside a product like an annuity that offers a performance buffer or locked-in growth as a means of partially cushioning losses. It’s worth noting, though, that few active funds actually outperform the market each year, which can require people to spend considerable time reviewing their options to find best-in-class active fund managers.
Work with a financial advisor to discuss the advantages and disadvantages of index funds and then review how the two approaches might fit in your financial plan.
- What is my goal for the money? People who want a simple way to maintain exposure to growth potential might prefer index funds. Those who want to maximize potential gains might consider active funds, understanding that active funds also carry the risk of underperforming the market.
- What are the tax considerations? Because active funds generally trade more and have more distributions, it can be beneficial to hold them in a tax-advantaged account, such as a 401(K) or IRA, and keep passive funds in a taxable brokerage account.
- What are the costs? People who want to avoid higher investment fees might prefer index funds.