J. Ojih
United States, where GDP rose at a mere 1.8% annual pace between January and March [4], and unemployment
still remained high despite all the reforms and bailouts implemented by Congress.
The effects of these developments are clear: many people are still out of work, consumer confidence is low,
and with the value of savings, retiree pensions, and other forms of investments severely eroded by the wide
fluctuations in the stock market, investors are jittery. The logical deduction from these developments is that, for
the modern day investors, the gold standard would be to put their money in those securities that would provide
capital preservation as well as ensure predictable steady returns. In this paper, I will argue, with evidence, how
investing in index funds (that is, a collection of stocks in a particular sector of the market that tracks an index
and are not managed by an individual [5]) can help investors keep investment costs down as well as reap signif-
icant investment returns over time via a combination of cost savings, low risk and longevity—the key factors
that make index fund returns float to the top in rankings. Before presenting the theoretical groundwork that
showcase the potency of index funds (with respect to providing investors with low-cost exposure to a wide range
of asset classes that has solid long-term track records), it may be worthwhile to describe the performance of
these funds over time.
2. The Index Fund Effect: Evidence from Performance
Broadly speaking, even though many super star fund managers fly around the world crunching reams of data
and dissecting industries with the ultimate intention of beating the market, the available evidence had continued
to show that index funds deliver higher returns than comparable actively managed funds. Independent studies
suggests that over the past 10 years, large-company index funds that track the S & P 500 and small company in-
dex funds that mimic the Russell 2000 over-performs the average gain for comparable actively managed fund by
as much as two percentage points a year. This important point may be clarified by the following two examples:
According to the available published evidence, when we look at mutual fund performance data over the past two
years, it would be observed that the S & P Composite 1500 beat 89.84 percent of all actively managed domestic
stock funds. In addition, over the past three and five years, those numbers, which continues to depict a clear
trend of S & P Composite 1500 over-performing actively-managed funds, were 73.24 percent and 67.72 percent,
respectively. This fact about actively-managed funds underperforming the index funds also holds true for the
bond funds, with the majority of active equity and bond managers in most categories lagging behind comparable
benchmarks. For example, over the past five years, 93.62 percent of actively managed long government bond
funds trailed the Barclays Long Government index [6].
There four main reasons for this. The first reason is related to the efficient market hypothesis, which states
that all markets are efficient in digesting information about individual stocks or about the stock market in gener-
al. This implies that when information arises, the news spreads quickly and is immediately incorporated into the
prices of stocks thereby making it impossible for investors to use technical and fundamental analyses to gain
above normal returns. Thus both the uniformed investors buying diversified portfolios at the tableau of prices
given by the market and the expert fund managers cannot always beat the market since they equally have access
to security prices that fully reflect all known information about the market. In other words, a novice investor can
obtain a rate of return that is as good as that achieved by fund managers [7].
The second reason that indexing works is due to low expense ratio-the annual fee that all funds managers
charge their shareholders [8]. Broadly speaking, the typical range of expense level for managing public index
funds is around 0.2% - 0.5%, which is much lower than the 1.3% - 2.5% (see Table 1) often charged by the ac-
tively managed funds [9]. Besides, index funds do not have the sales charges known as loads, which a common
fee is charged by many mutual funds. As a practical matter, shelling out less in costs this way is a huge advan-
tage because keeping expenses down is a priority for every investor as every dollar of expenses is one less dollar
of gross return that goes to them. It should be stated here that these ratios are not as noticeable for investors in
bull markets when returns are. However, the higher expense ratios become more conspicuous in bear markets
because they are directly deducted from the meager returns. For instance, if the return on a mutual fund is 8%
and the expense ratio is 3%, then the real return to the investor is only 5%.
When it comes to certainty in terms of broader diversified exposure to the financial markets, index funds
reign supreme—the third reason why indexing outperforms managed funds. Thus by choosing these funds, un-
informed investors know exactly what securities or portfolios they have at any given time. In the bigger picture,
investors interested in large-cap stocks can put their money in, say, a Standard & Poor’s 500 index fund. Those
