Index Funds Gain Momentum in Rocky Markets

As financial markets remain volatile, index funds may be an oasis of stability.

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Happy Birthday, index funds. The financial crisis has shown how much we need and love you guys.

On Aug. 31, 35 years ago, Vanguard released the first ever index mutual fund – the Vanguard 500 Index Investor. The fund was based on a simple premise. It would track the performance of the Standard & Poor’s 500 Index, which in turn tracks the stock performance of the largest companies in the U.S.

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Now, there are about 290 stock and bond index funds, along with 990 exchange-traded funds in the U.S., with approximately $2.3 trillion in assets. Actively managed mutual funds still hold more assets — investors have $7.3 trillion in them — but the tide has shifted in favor of index funds. On a year-to-year basis, index fund inflows through June totaled $183 billion compared to just $138 billion for traditional mutual funds.

Why would rocky markets make index funds more attractive than putting your money in a fund with someone who is actively picking stocks or bonds? In a word, it’s all about value. According to U.S. News & World Report, the average return of the stocks in the S&P 500 is 9% annually. But the average annual gain of actively managed funds, the magazine reports, is only 7.5%.

In addition, data from Standard & Poor’s Indices Versus Active (SPIVA) scorecard shows that actively managed funds lagged behind their category’s benchmark index over a five-year period, ending in December 2010. SPIVA also says that 75% of actively managed funds couldn’t beat the S&P MidCap 400 index, while 63% of small-cap mutual funds couldn’t beat the S&P SmallCap 600 index. Index fund investors, on the other hand, know what they’re getting. Generally, whatever their benchmark index earns, that’s what the investor earns, or close to it.

But that’s just for starters. Index funds also offer lower management fees than actively managed funds. That can significantly impact market returns, as traditional mutual fund investors have to lug around a 1.5%-to-2% fee burden that index fund investors don’t have to. Most index funds have fees that are well below 1%, and that makes a big difference on Wall Street.

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A 2010 study from Morningstar shows that, from 2005 through 2010, mutual funds ranked in the bottom 20% in fee charges generated higher returns than mutual funds in the top 20% of fee charges.

Maybe that’s why index funds have far from petered out 35 years after they were introduced. In fact, they are probably a stronger influence in the investing world they have ever been. After all, who’s going to turn their back on low fees and higher returns?