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.
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.
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.
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
- 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.
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.