Wednesday’s Word: Index Fund

By Brook Ptacek, Fall 2018 IAC Student Intern

Everyone wants to beat the market. Go against the grain. Change the status quo. But beating the market is tough.  In fact, it’s more than tough–it’s almost impossible.

Index funds are not out to beat the market. In fact, index funds are investment instruments that track the market’s performance.  The SEC likes to describe these indexes as “baskets” of stocks that represent a particular industry or sector of the financial market.  You ever hear of the DOW Jones Industrial Average or S&P 500? These are indices. Index funds are funds set up by outside company to track these indices, which are tracking the performance of the market as a whole.

Since index funds merely track what is occurring in the market, they do not require financial analysts to actively pick securities for clients to invest in, which substantially cuts back the fees associated with these investments. This is because the investor does not have to pay the additional fees for buying and selling stocks, which add up over time. Instead, you, the investor, are betting on general growth in the market over time.

In his 2016 letter to investors, Warren Buffet disclosed the results of a nine-year wager he made: he bet no investment pro could select five hedge funds that would match-not beat, just match-the performance of an unmanaged S&P 500 index fund. The result was astounding. Over nine years, the compounded annual increase of the index fund was 7.1%.  The selected hedge funds, on the other hand, delivered an average of 2.2% compounded increase annually.  As Buffet put simply, “[t]hat means $1 million invested in those [hedge] funds would have gained $220,000. The index fund would meanwhile have gained $854,000.”  In other words, by an investor merely betting on the market to perform over time, he or she would have seen a 74% higher return.

So next time a financial adviser tries to tell you they can beat the market, ask how they performed against an index fund in the past, recognizing that past performance doesn’t predict future results.  Most likely, they didn’t beat the index.