Index Funds' Competitive Advantage

In 1976, the founder of Vanguard, John Bogle, introduced the world's first index fund named the Vanguard 500 Index Fund. The purpose was to create a basic, low-cost portfolio that mirrors the performance of the S&P 500 stock index.

Nearly, four decades later there are now over 300 index funds accounting for 24% of assets under management.

One big reason for this surge is the COST. It is a competitive advantage in a cutthroat world.

In the actively managed fund, fund manager makes decisions on your behalf about which securities to buy, hold or sell. The premium, or cost, you are paying for is the expertise of the fund manager. It is like paying your fund manager a salary and it is not cheap.

Index funds, by contrast, do NOT require the expertise of a fund manager. Money goes into the fund and is then used to purchase the individual stocks that make up the index being tracked. This results in lower expense ratios (cost) for index funds over actively managed funds.

The typical expense ratio for an actively managed fund is about 1.5%. With an expense ratio of 1.5%, a mutual fund is cutting itself in on 1.5% of the total money in the fund every year.

Meanwhile, in the wonderful world of index funds, the expense ratio is typically around 0.25% and gets as low as 0.05% (Admiral class requiring $10,000 in balance) for the Vanguard 500 Index Fund.

Those higher costs for an actively managed fund can make staying competitive all the more difficult for managers. In 2012, for example, the S&P 500 gained 13.4%. In order to simply break even with the benchmark, the average fund manager would have had to outperform the index by 1.5%.

Another competitive advantage for index funds is lower capital gains taxes compared to actively managed funds.

To outperform their benchmarks and indices, actively managed funds, by necessity, are required to (and do) take on more risks than necessary. Many of the times, they trade in stocks much faster, which results in higher turnover ratios, and ultimately higher capital gains taxes for the customer.

In case of an index fund, the capital gains are the result of fund inflows/outflows and not due to excessive trading for higher returns by the fund manager.

That is not to say actively managed funds cannot out perform indexes. Many do.

BUT, research has shown that higher performance equates to bumpy performance.

Vanguard looked at the 15-year records of all the actively managed U.S. domestic equity funds that existed at the start of 1998. Vanguard found that not only are long-term out-performers rare (only accounting for only 18% of the funds), but they also experience numerous and often extended periods of under-performance leading to the bumpy ride.

AND, according to this Business Insider article.

Looking at advanced portfolios holding 10 asset classes between 1997 and 2012, researchers found index fund portfolios outperformed comparable actively managed portfolios a staggering 82% to 90% of the time. And the longer investors held those investments, the better shot they had at outperforming active funds over time.

Therefore, it is getting harder and harder to deny the power of index funds due to their competitive advantages over the actively managed funds.