Introduction

The only rational path for individual investors is to invest in passively managed index funds. You cannot buy a market index. Instead, you must buy either a mutual fund or an ETF that mimics a market index. Index funds track the performance of a particular market benchmark as closely as possible. These funds do this by buying all (or at least a representative sample) of the securities in the benchmark.

A traditional index fund represents the entire stock market. It thereby eliminates individual stock risk, market sector risk, and portfolio manager selection risk. Thus, only stock market risk remains.

Indexing now represents approximately 30% of all investment dollars. Beyond individual investors, indexing is used by large corporations, local and state governments, and even the federal government employee’s Thrift Savings Plan (TSP).

Index mutual funds have $2 trillion in assets. ETF index funds have a similar amount. Surprisingly, that means that approximately 70% of investment dollars are still in actively managed funds! However, the percentage investment dollars in passive funds continues to grow. According to Moody’s, “index funds will grab more than half the assets in the investment-management business by 2024.“1

Compared to actively managed funds, passive index investing:

• has a higher rate of return over time;
• is more cost efficient, with minimal expenses: management fees, advisory fees, and brokerage commissions are lower;
• is more tax efficient: portfolio turnover is lower; therefore, taxes are lower; and
• is more predictable and, thereby, simplifies investing (so, you will have less anxiety).

Recall the discussion about market risk, earlier: investing in index funds eliminates individual stock and stock group risk. Because you are not actively investing, you also eliminate manager selection risk. Therefore, only market risk remains.

Mutual Funds

ETFs

The advantages of ETFs include:

• some have lower fees than their corresponding mutual funds
• they can trade at any time during the day (rather than at market closing)
• they are more tax efficient than mutual funds because you can redeem them without generating a taxable event, and
• they may be optimal for lump sum events such as an IRA rollover.

However,

• ETFs are not appropriate for periodic payments due to brokerage charges (no load mutual funds have no transaction fees), and
• ETF dividends may require additional transactions (no load funds automatically reinvest all dividends).

The bigger issues with ETFs are:

• The overwhelming majority of ETFs are not based on broad markets, and
• Purchasers of ETFs may be tempted to depart from long-term value-based investing and use them for short-term speculation.

Summary

Coming soon!

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Updated on January 31st, 2019