Index funds are passively managed funds that mimic the holdings of an index. Generally, they trade less than actively managed funds and charge lower fees to cover their expenses. But do these funds beat the market?
In most cases, index funds beat the market. This is often due to their low-cost nature and tax efficiency. However, in exceptional circumstances, active funds can beat index funds.
In this article, I will explain why index funds tend to beat the market. I will also point out some categories of stocks that often outperform index funds. Read on for more insights into these, and five crucial things to know about passive funds.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
Why Do Index Funds Beat Active Funds?
Index funds outperform actively managed funds because they’re cheaper and more tax-efficient. Notably, the management fees and taxes investors pay for active funds accumulate in the long term. So these funds must generate higher returns than index funds to match the profits from passive trading.
Let’s take a look at the rundown of how costs and taxes affect market performance.
Cost
Active fund managers typically charge a fixed annual fee, which can be as high as 2%, for producing results that are no better than those of the market average index fund. This means that active managers have to beat the market by an additional 2% every year to break even with the passive manager.
In contrast, passive managers produce these similar results at a much lower cost.
Tax Efficiency
Index funds are relatively not too heavy on dividend payments that are taxed as ordinary income, unless you invest in a dividend focused fund. Plus, index funds typically have a lower turnover rate, thereby resulting in overall less taxable events.
In comparison, active funds have a higher turnover because they base their buy and sell decisions on the performance of individual stocks. Additionally, passive investments in index funds are not subjected to capital gains taxes very often because they buy and sell stocks only when an index changes its components.
On the other hand, investors in active funds must pay a tax bill for each trade that produces a taxable event.
These costs add up over time and reduce a fund’s market performance relative to a passive strategy. Even when active funds have a higher return than the market average, their higher fees may lower net-of-fee performance.
Here’s a video that explains how index funds work:
That being said, based on Morningstar data as of June 2020 (link in article sources down below), the stocks that tend to beat index funds include:
- Junk bonds
- Global real estate funds
- Emerging market funds
4 Crucial Things to Know About Index Funds
Let’s now switch gears for a moment and look at four crucial things to know about passive funds.
1. Index Funds Provide Broad-Market Exposure
Index funds provide diversified exposure across:
- Multiple asset classes
- Sectors
- Geographic regions
Index funds track indexes that include stocks from various industries and regions.
For example, the S&P 500 tracks top US companies. However, it also includes small-cap and mid-cap American companies not included in other major indices like the Dow Jones Industrial Average or the MSCI EAFE.
As a result of this broad market coverage, an investor can benefit from global growth without taking on a significant risk.
For more insights into diversification and its benefits, I recommend reading Beyond Diversification (available on Amazon.com). The authors explain how to allocate investments in different classes to get the results you want, making it a worthwhile read for any investor.
2. Passive Funds Provide Liquidity for Institutional Investors
Index funds offer liquidity for corporate and institutional investors as a result of their:
- High trading volume
- Low transaction costs
- Ability to trade on exchanges
In comparison, the transaction costs of buying and selling individual stocks can be very high for institutional investors like mutual funds and pension plans.
3. Index Funds Have Lower Volatility Than Active Funds
Index funds have a lower level of volatility than actively managed funds because their holding period typically consists of several years, which significantly increases the ratio of positive to negative fund returns.
In addition, index funds tend to sell stocks more quickly than active managers do when the prices of the stocks decrease well enough for it to be out of the index being tracked.
4. The IRS Treats Index Funds as Passive
Index funds are treated as passive for tax purposes because they don’t take significant positions in individual stocks. Instead, index funds passively track their respective indexes by holding a small percentage of each component stock in proportion to its market value.
This reduces trading activity in the index funds that often results in high capital gains for active managers.
That said, here are some index funds worth mentioning:
- MSCI EAFE: This index fund captures large and mid-sized companies across 23 developed markets, including the United States, the United Kingdom, Japan, Germany, and France. You can also find ETFs that track specific countries within this exchange-traded fund.
- S&P 500: This index fund tracks the 500 largest and most liquid US stocks. The S&P 500 includes small-cap and mid-cap companies that might not be included in other major indices like the Dow Jones Industrial Average or the MSCI EAFE.
- Russell 2000: This index fund consists of stocks from 2,000 small American companies.
- Vanguard Total Stock Market Index: This index fund is designed to track the performance of the US stock market as a whole. It includes 3,980 US-based companies with readily available price and market data.
Pros and Cons of Investing in Index Funds
Like other passive investments, index funds have their pros and cons.
Their advantages include:
- Index funds are inexpensive because they don’t require extensive research or investment in expensive portfolio managers. Their expenses are lower than active fund costs because they track indexes instead of trading stocks frequently to generate returns.
- Indexes provide broad market exposure that reduces the need for derivatives to minimize risk. This eliminates counterparty risks associated with derivatives like futures contracts or swaps.
- Passive funds minimize tax liabilities because they sell stocks when markets decline and purchase them when markets rise. Due to its low turnover rate, an index fund’s strategy produces fewer taxable events than an actively managed fund with a higher turnover rate does.
Their disadvantages include:
- Index funds’ returns are closely tied to overall market performance. As a result, the success of index funds is dependent on the US and global economies. In comparison, active managers can pursue strategies that increase their chances of outperforming indexes when markets decline by selecting stocks with solid fundamentals in periods of economic downturns.
- Passive funds are inflexible. They limit themselves to replicating the performance of an index, which can undermine returns when markets increase at a faster rate than the index. In comparison, active managers offer more flexibility in their investment strategies and can take advantage of unpriced opportunities by trading stocks outside of indexes.
- Indexes don’t factor in all information available to active managers, such as private company ownership and values. This limits the ability of passive funds to beat benchmarks and makes them less advantageous than actively managed ones.
Pro Tip: It’s essential to monitor your portfolios, regardless of whether they’re built on passive or active approaches. A comprehensive investment strategy should combine both an increase in value via passively tracking market indices while also holding some actively managed funds with a track record of outperforming benchmarks.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
In a nutshell, index funds can beat the market, and they do so most of the time. Similarly, the market sometimes outperforms passive funds, but this happens only 24% of the time.
That said, investing in indices is a solid choice for risk-averse investors because they:
- Are inexpensive.
- Provide liquidity for institutions.
- Have lower volatility than active funds.
- Are treated as passive investments for tax purposes.
However, index funds also have disadvantages, including the fact that they’re inflexible and produce smaller returns than active managers when markets perform well.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
Recent Posts
Exploring Social Trading: Community, Profit, and Collaboration
Have you ever wondered about the potential of social trading? Well, that curiosity led me on a fascinating journey of surveying over 1500 traders. The aim? To understand if being part of a trading...
Ah, wine investment! A tantalizing topic that piques the curiosity of many. A complex, yet alluring world where passions and profits intertwine. But, is it a good idea? In this article, we'll uncork...