What The Heck Is An Index Fund?

Updated : Oct 26, 2019 in Articles

What The Heck Is An Index Fund?


From an early age, we’re taught to celebrate
winners. Look up to champions. Revere Gold-medalists. We make fun of “participation trophies”. I mean, when was the last time you heard somebody
bragging about having a few dozen followers or a perfectly average salary? So how do you explain the explosion in popularity
in an investment tool that offers nothing more than a guarantee of average results? Nothing fancy… just average. Strange as it might seem at first glance,
the meteoric rise of the “Index Fund” is a lesson in how sometimes, aiming for “average”
might be the “best” strategy of all. In an earlier episode, we explained how mutual
funds offer numerous benefits — like low share prices, broad diversification, convenience,
and ease. Their debut in 1924 ushered in a golden age
for active portfolio managers. Professional investment management was suddenly
no longer just for the ultra-wealthy. The American middle class poured their savings
and retirement accounts into mutual funds with abandon. Today, with nearly 10,000 mutual funds available,
it can look like a Cheesecake Factory menu, endlessly long and complicated. So most fund managers compete to deliver the
maximum amount of “alpha”. That’s just investor-speak for how much
BETTER the portfolio manager did than the market average. The way managers measure their success is
by comparing their returns to an “index”. An index is a hypothetical portfolio that
represents a segment of a financial market. For example, the S&P 500 index measures the
average stock gains or losses of the 500 largest companies in the US. There are indices for virtually every type
of investment all across the world: precious metals, oil, bonds, even a pork carcass index. Their main use is as a comparison tool. For a long time, trying to “beat the index”
with your mutual fund made sense to most investors. I mean, who would want to put their money
with a fund manager who charged expensive fees but failed to beat the market most of
the time? But then, a dirty little secret was uncovered. Most professional fund managers consistently
fail to meet-or-beat their index by a wide margin. One study found that, 90% of active-fund managers
did worse than their relative index. And these are supposed to be the best of the
best with Ivy league educations, decades of experience and sophisticated trading tools. There are a few factors that make it difficult
for fund managers to “beat the market”. The first is fees. Actively managed mutual funds employ teams
of researchers, analysts, and traders. That costs money. And you, the investor, end up paying for it. Actively managed funds have annual fees on
average of around 1.4%. In other words, your mutual fund has to make
1.4% per year just to keep you from LOSING money! A second key factor is that humans are really
really bad at telling the future. In the 1973 book, “A Random Walk Down Wall-street”,
Burton Milkier suggested that investment markets are too complicated and, well, random, to
be consistently predicted. Researchers found that you’d do just as
well picking stocks blindfolded as you would giving your money to a portfolio manager. No seriously, in a contest run by the UK Observer,
professional portfolio managers tested their skills against the stock-picking prowess of
a cat named Orlando. Orlando shredded the pro’s. Milkier suggested the creation of a new, low-cost
mutual fund that simply buys the hundreds of stocks within the index, and doesn’t
jump from stock to stock, trying to beat the market. That sounded like a great idea to a guy named
John Bogle. In 1975, he launched Vanguard’s “First
Index Investment Trust”. No more promises of beating the market — the
only guarantee was that your investments would do slightly worse than average (since even
index funds have minimal fees). Sound a little… underwhelming? Yeah, it did to investors at the time too. The fund was ignored – or outright mocked
– for years, and many thought it wouldn’t survive. Spoiler Alert: it did. Over the last half-century, more and more
investor’s started wising up and today Index Funds and Index ETFs are more popular than
ever with nearly 7 trillion dollars resting in index-type funds. It seems the promise of consistently “average”
results doesn’t sound so shabby to investors any more. This is also thanks to the investing Godfather…Warren
Buffet. In 2007 he made a million dollar bet with
the world’s best hedge-fund managers that they couldn’t out-perform an S&P 500 Index
Fund over a 10 year period. And wouldn’t you know it, despite weathering
the 08 crash, the index fund trounced the hedge funds, averaging an annual 7.2% return,
compared to the hedge funds measly 2.2%. Now, to be clear, index funds are not the
“perfect investment.’’ There is no such thing. But Warren Buffett famously quipped that Index-Fund
investing is the best move for 99% of investors out there. So if you decide to join the club, start simple
and don’t forget to diversify! For example, a basic blend of three broad
indices would allow you to diversify into a huge spread of countries, companies, and
asset types. Index funds are available through most fund-companies
and can be bought within a retirement account like an IRA or 401k. And unless you’re a seasoned investor, speaking
to a professional to set an ideal blend is a smart step. There are also online “robe-advisor” services
that can automatically make the blend for you, based on your goals and risk tolerance. So next time your momma asks if you’re doing
your best, say… actually Warren Buffet says that I should just strive to be average! She’ll be thrilled. And that’s our two cents! Hey guys! It’s Philip and Julia again. Question: How can you make your favorite meals even more delicious? Add a dash of science of course. Serving Up Science is a PBS Digital Studios show hosted by history buff, science writer and foodie Sheril Kirshenbaum who is serving us science backed answers to all of our biggest food questions such as: Should you let your meat rest? What’s better, wild of farmed salmon? What makes blue cheese so stinky? Ah! I think you mean delicious. So, head on over to Serving Up Science and tell them Two Cents sent you. We’ll be nerding out right along with you. What else would you like to know about Index
funds? Ask your questions in the comments section.

100 Comments

  • Something I've seen is that mutual funds will advertise their portfolio's returns using retroactive data from before the fund was assembled. This effectively seems like false advertising to me as future returns are not necessarily correlated with past returns. Something to keep in mind.

  • This channel is perfect for lowering the barrier to entry on financial literacy. You should try to advertise it to schools nationwide!

  • I love this videos and ive learned a lot from them. BUT… Every video ends up with "you should talk to a professional "X" before doing anything" Where do I find this "professional" people? I dont like to just google it because then im finding a "Professional" in Google Ads, not finances.

  • Just want to inform you, the link for Serving Up Science brought me to an old channel of theirs, I think. Cause I tried to doddle around and found PBS Food channel. Have the same host and theme. I think that's their channel now. Just fyi.
    Love this vid btw. Julia is more blooming than usual. Thank you guys for all the finance info help.

  • This is all interesting stuff, and it's teaching me what to do once I have money to lay with. But is there any advice you can give about pulling yourself out of poverty? So many of us tradesmen work 40+ hour jobs, (often more than one job) and still barely survive paycheck to paycheck. I myself am constantly one ER visit away from losing everything I worked so hard to build.

  • RIP "Jack" Bogle!!! Thank you so much for fighting for the little guy!

    Edit: You can watch John Bogle talk about investment right here on youtube in excellent long-form interviews.

    Edit #2: Try looking up the stock ticker VOO – this is the Vanguard ETF with the lowest maintenance costs!!

  • Great info and history lesson too! Index funds, thanks to the late, great Jack Bogle have changed so much of how we optimized investors operate and I actually shared a little bit of my take on index funds here. 😀https://youtu.be/j1PDD0YjvyM

  • I have learned a lot in this channel. As a new college teacher here in the Philippines, this channel helps me understand finances better. Thank you.

  • 3:47 I still have questions about those studies. they don't seem truly random to me. because someone had to pick the stock to layout that the cat could walk across. So maybe the subconscious has a little strong effect on the market than we think. can we compare people trying to pick random stock to actually random picks and see if there's a statistically significant difference?

    Just a thought for anyone looking for an experiment to run.

  • This is really good stuff, but I wonder if since there's so much invested in index funds following large companies such as the ones in the S&P 500, won't those companies end up being over-valued, since so much stock in those companies is automatically from the index funds? It makes me think that the companies that are almost but not quite big enough to be in the S&P 500 might be particularly good investments since if they can get big enough they'll get that huge boost from all the funds invested in the S&P 500!

  • Mutual fund fees are annual, not one time.That means that if you have $100,000 in your retirement account and fees are 1.4%,you are paying $1400 per year, EVERY year. It will be deducted automatically.Because of the compounding effect,this will eat up more of your savings than you think. Index ETF's fee is 0.043% for a S&P 500 fund.Over long time, returns for index ETF's are more reliable and higher.

  • Enforce these videos in high school and I guarantee the number of wealthy individuals will increase for generations to come.

  • From my limited understanding, isn’t the market a zero sum game? Meaning that for some stocks to gain others have to lose, so if everyone just went with index funds wouldn’t it just level out and be a +0% gain?

  • Great vid, I learned more things about index funds thank to your vid! Can you guys think about making a video showing example of a portfolio of "3 or 4 index funds" that give AVERAGE annually nice return (7%) =) ? Thanks

  • With market at an all time high now, does it make sense to move 401k and IRAs to money market funds? That way when the market crashes, I can buy the same stocks I have now for much less value and hold them and ride the rise again after that. I am no where close to retirement so I have time to invest.

  • I was so excited to hear about Serving Up Science… but it looks like they've only posted 2 videos of 2:58 seconds combined time since 2018 (2:39 min for one and 0:19 min for the other). Do you know if they're posting more? or there're some hidden videos that I just could not see? Thanks.

  • Is not a question about ETFs really but Stash and Acorns offer ETFs and Robinhood offers stock trading too sooo can you guys make a video about those investing apps? Are they actually any good? Do people see "average" returns? Lol great video by the way!

  • Can you invest in index funds without it being a retirement account? Like could I put money I want to be able to access in 10ish years into an index fund without any penalties about it being taken out?

  • Does All country have index or mutual funds, if so what are other common names that have the same meaning with index or mutual funds?

  • I always said index funds are the best and simplest form of investing for the long term.

    Sure mutual funds beat index funds for some time but in the long run, index funds are the winners.

  • So I went to check out Serving up Science but there's just two videos (one of them being the channel intro), and both uploaded over a year ago… Am I missing something?

  • I REALLY ENJOY YOUR VIDEOS , and just wanted to say THANK YOU for spending the time to develop MEANINGFUL content. I have been inspired to make a channel of my own and would appreciate the support. Thank you!

  • Great explanation! Bogel sure changed the game with Vanguard index funds. I talk a little bit more about them and how to start picking some specific funds to invest in on my channel!

  • Hey guys! I love this channel. I was wondering how one goes diy indexing. If I know what stocks are in the index, why can’t I just buy them all myself?

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  • I love you guys because you always explain things using historical data. I was totally happy with this video until the recommendation about serving up science. Did you guys hear about the book 'How not to die'? If not, I strongly recommend it. It feels disheartening to see people being logically consistent in one area(finance) and totally inconsistent in other areas (nutrition). That being said, keep up your good work.

  • 3:43

    So, you’re telling me that getting a cat would give me the best return on investment? Great! I wanted to get a cat anyways.

  • One of my subtopics in my paper I just planned out for class on Tuesday is Index Funds. Thanks for giving me a pbs citable source!

  • Who needs to pay the fees of a broker when you can just get a cat to do a better job than them?

    You’d probably do better making stock decisions while drunk than with a broker

  • You misspelled John Bogle's name at @3:59. It's B-O-G-L-E . . . John Bogle – the godfather of the FI/RE movement.

  • Amazing video 👌 can you guys maybe do a video about investment strategy for people starting investing only in their late 30s ? 🙏🙏🙏

  • As a person who hates uncertainty, this really hits close to home. I'd rather have my investment grow at a constant rate than have it fluctuate between extremes or even go to negative figures.

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