Index funds attempt to replicate, as closely as possible, the securities and structure of a market benchmark, such as the S&P 500®. In line with this goal, index funds are expected to earn a return equal to their benchmark, less a small fee for administrative and management costs.
With an index fund, there is no surprise in performance. When the S&P 500® index goes up, index funds benchmarked to that index should go up by nearly an identical amount. Because index funds are designed to mirror the movement of a market, they are evaluated based on tracking error, or how closely a fund matches its benchmark.
One reason to use index funds is the consistency of performance. Over time, index funds achieve higher returns than a vast majority of actively-managed funds that try to beat a benchmark. Why? The short answer is that index funds have considerably lower expenses. The cost to manage an index fund is far lower than an active fund because there are no stock analysts to pay, no research to buy, and no excessive commission payments to Wall Street brokerage firms for access to information and IPOs.
The average cost of an index fund is about five times lower than the average mutual fund. The lower cost of an index fund gives it a significant performance advantage over time. Although active fund managers may be able to conduct the research that might enable them to select stocks that outperform the market, they cannot do it with enough consistency to overcome the higher expenses in those funds.
In the final analysis, most people are better off in a low-cost index fund than trying to beat the market. The benefits of low-cost index investing extends to all categories of stocks and bonds across the globe.
For more detailed information regarding index investing, please visit our Index Investing Article library.