What is the Index Fund?

Throughout the 20th century and even into the 21st century, stock brokers have relied primarily on one thing to generate revenue: the tendency of investors to believe that stock brokers have some sort of special knowledge about markets and some kind of hidden insight into how stocks will perform. In 1951, future founder of Vanguard, John Bogle graduated from Princeton and published a thesis titled, “Mutual Funds can make no claims to superiority over the Market Averages.” Within the following two decades, further research would be conducted by economists and financial researchers to reveal Bogle’s paper to be true. And thus was born what would become the stock broker’s worst nightmare–the index fund.

An index fund compiles a large amount of companies, buys stocks from each company in the group, and then uses the average performance of the entire group as a benchmark for market performance. The rational is that, if the right group of companies is chosen, then performance of the group will be fairly representative of the entire market. And, as has already been mentioned, history has shown the rational to be empirically true. Consistently, index funds have outperformed the market and left investors who have used them much better off.

In 1975, a year after he had founded the Vanguard Group, John Bogle started The First Index Investment Trust–one of the first index funds in history. At the time, he was derided by economists and investors as the program was viewed as too conservative and unlikely to produce desirable returns. However, these pundits were proven wrong. Over time, the index fund proved viable and was eventually renamed the Vanguard 500 Index Fund–tracking the Standard and Poor’s 500 Index. Bogle predicted in 1992 that the fund would outperform the Magellan Fund–one of the most notable mutual funds in the market–by 2001. In 2000, his prediction bore out and the Vanguard 500 Index surpassed the Magellan Fund.

There are a vast number of index funds available to investors. The Russell 2000 tracks small companies, the DJ Wilshire 5000 tracks the entire market, the MSCI EAFE tracks foreign stocks, and the Barclays Capital Aggregate Bond Index tracks the entire bond market. The most popular indexes, however, track the S & P 500–which uses the top 500 publicly traded US companies as a benchmark.

Besides the fact that index funds consistently outperform the market, they are also more beneficial to investors because there are less fees involved in using them. Index funds are known as a form of passive investing. Since the index fund more or less runs itself, money managers are not needed to handle transactions and management of individual stocks. And that is exactly why index funds are the stock broker’s most horrible nightmare. In a nutshell, it’s because they can’t make any money from you when you use index funds. When you use index funds, you don’t even really need a stock broker.

Are you considering investing in an index fund? Do you have more questions about how they work or which ones to use? Feel free to reach out to us and schedule a free consultation. We would love to help you be more successful in your investing.