Guest post by Vered DeLeeuw*

Index funds are low-maintenance, low-cost mutual funds designed to follow the price fluctuations of a broad index, such as the S&P 500. In general, there’s nothing too exotic about them and in fact, they are quite boring if you’re looking for an investment that can significantly outperform the market – index funds do nothing more than try match the market. But when it comes to long-term investment success, index funds work.

I love index funds. That said, I do also hold several actively managed funds in my portfolio – no load, low cost, low turnover, high performance funds that I have found over the years. But when it comes to actively managed funds, the sad reality in my view is that the few excellent funds that I hold are quite rare.

In fact, research shows that over time, index funds beat the returns of most actively managed funds. The main reason: the higher expenses of actively managed funds cause them to lag behind index funds. So except for the few rare gems out there, index funds make more sense for most investors.

Of course, under the efficient market theory, you should only invest in index funds. This theory states that all markets are efficient, and that it is impossible for investors to gain above normal returns because all relevant information that may affect a stock’s price is already reflected in its price. Since you can’t beat the market, you might as well join it via index funds. It’s the school of thought that says you should not invest in a company, or in a group of companies, but in the market as a whole.

Here are the main reasons I love index funds:

1. Low costs. Since costs are arguably the most important factor when it comes to investment success, the lower a fund’s costs, the more chances it has of performing well. While some actively managed mutual funds will outperform the market over the short term, their costs usually make it very difficult to outperform an index fund over the long term. Index funds costs vary, so make sure you find the lowest-cost fund offered in each sector.

2. Cheap, effortless diversification. Many brokers steer investors toward actively managed funds in the name of diversification, but index funds offer plenty of diversification. You can use an index fund to get broad exposure to large cap, mid cap and small cap US stocks, to growth and value stocks, and to international stocks, including emerging markets. If you add exchange-traded funds to the mix, you can get exposure to almost any index you can think of, including precious metals, real estate, information technology, health care and energy. Of course, simply owning a total stock market index fund, which owns stock in thousands of US companies, provides plenty of diversification!

3. Tax efficiency. If you hold your funds in a taxable account, you should pay close attention to each fund’s turnover, because the more a fund manager trades, the more tax you will pay – even if you haven’t sold the fund. Since index funds generally have a very low turnover, they are more tax efficient than most actively managed funds.

4. Superior performance. This goes back to reason #1 to hold index funds. Since index funds feature low costs, they tend to outperform most actively managed funds in the long run. Just like returns compound, the same thing happens with expenses. Each additional half-percentage point is costing you a lot in the long run.

5. They save you from the futile game of trying to time the market. While some claim that index fund investing is like giving up as an investor before you even try, I disagree. Not trying to time the market, or to beat the market, is not giving up. It reflects a different approach to investing – an approach that believes in a well-diversified, long-term portfolio as the best way to slowly and reliably grow your nest egg.

As I said, while I see index funds as an important core part of any portfolio, I don’t necessarily rule out investing in actively managed funds altogether. I do recommend being very careful when selecting these funds and making sure they are as low-cost and as tax efficient as possible.  You should also insure that no matter whether you hold passively or actively managed funds, your holdings correctly reflect an asset allocation that’s in line with your financial goals and preferences.

*Vered DeLeeuw is a freelance writer and blogger. She writes about a wide range of topics, including personal finance, real estate, marketing and self-improvement, and is a frequent contributor to the Jemstep blog. Vered lives with her husband and two children in the San Francisco Bay Area of California.

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