How to Use Index Funds to Your Advantage

Get the Most Out of Your Index Funds

money growing on vine
Learn how to use index funds and grow your money. Getty Images

You've heard that index funds are a wise investment but how do they work and how can you use index funds to your best advantage?

If you've decided to buy index funds, it's possible that this is one of the best investment decisions you've ever made. But like other investment types and mutual funds, there is a right way to invest in index funds and there is a wrong way. Let's start our lesson on using these passively-managed mutual funds with the basics of index funds.

Advantages of Index Funds

When John Bogle started Vanguard Investments over 40 years ago, his founding principle was that an index fund that passively holds the stocks in a benchmark index, such as the S&P 500, could perform better in the long run than most actively-managed funds that try to "beat the market." Now some of the best Vanguard funds, like Vanguard 500 Index (VFINX), Vanguard Total Stock Market Index (VTSMX), and Vanguard Total Bond Market Index (VBMFX) are three of the largest mutual funds in the world.

But how do index funds beat actively-managed funds in the long term? One of the strongest advantages of index funds is that their passive nature significantly reduces the costs of running the mutual fund. For example, if a mutual fund's expenses are higher than average, these expenses will reduce the return to investors more than average funds. These expenses are expressed in the fund's expense ratio.

 

In simple terms, if a fund's total return before expenses in one year is 10% but the expense ratio is 1%, the net return to investors that year is 9%. Now consider the fact that many mutual funds have expense ratios as high as 1.5% or more, and that most index funds have expense ratios lower than 0.5%.

That 1% in return saved every year with index funds can mean thousands of dollars over long periods of time.

Another advantage of index funds is that they have lower turnover than the actively-managed funds. A mutual fund's turnover ratio is how much of a fund's portfolio is replaced every year. For example, if a mutual fund invests in 100 different stocks and 50 of them are replaced during one year, the turnover ratio would be 50%. High turnover increases the costs of managing the fund but it can also mean more taxes to the investor in the form of capital gains distributions.

Another advantage of index funds, one that is not often discussed in financial media, is that they eliminate something called manager risk, which is the risk that the portfolio manager of an actively-managed mutual fund will make mistakes that are common in all human beings, no matter their skill, experience or education level. Common mistakes fund managers make are centered around poor timing decisions or simply bad security selection. These mistakes can be caused by emotions, such as greed or fear, or a miscalculation of the emotions of investors. Since index funds are passively managed, these manager mistakes don't occur.

One more advantage of index funds is that they are often more diversified than other mutual funds. This is because they often hold hundreds or even thousands of stocks or bonds, whereas actively-managed mutual funds might only hold 50 to 100 stocks or bonds.

Best Uses of Index Funds

Although index funds are often more diversified than actively-managed funds, it can be a mistake to hold just one fund in your portfolio. And remember that index funds and actively-managed funds can work together well. Therefore it can be a good idea to use an index fund, such as one of the best S&P 500 Index funds, as a core holding. This portfolio structure is called core and satellite. The index fund is the core, which might represent 30 to 50% of the portfolio, and the satellites might include a foreign stock fund, a small-cap stock fund, a bond fund, and possibly a few sector funds.

Also remember that index funds have low turnover. Therefore they tend to have lower capital gains distributions than actively-managed funds. For this reason it is smart to hold index funds in a taxable brokerage account and to keep actively-managed funds and funds that pay dividends in tax-deferred accounts, such as IRAs and 401(k)s.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.