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Index Fund Investing

The available facts about index funds include elements of practice, theory and arithmetic.

Theory element

According to theory:

  • Gross returns that a group of investors has made must equal gross returns the total stock market has earned.
  • Net returns that a group of investors has made must be equal to the market returns minus the amount of the advisory fees and other expenses.

Practice element

What theory says is what practice proves. This means that net returns that the equity mutual fund is equal to the returns on the corresponding stock market indexes after subtracting the operating and transaction cost that have been incurred during the fund management. In recent years, less than a third of the actively managed funds have managed to outperform several index funds. Nevertheless, no one expert has managed to provide a procedure or whatever forecast method to establish in advance the actively managed funds that have the potential of outpacing the index funds. Therefore, until sound facts are provided, this outperformance of the actively managed funds can be attributed to share luck or concurrence of circumstances.

Arithmetic Element

A simple calculation can be made to illustrate the numeric superiority of index funds compared to an average fund. The following example provides the striking difference:

  Initial Investment Annual Returns Amount after 20 years
Index Fund $20,000 12.4 % $207,200
Average Fund $20,000 10.9 % $158,400
Difference: $48 800

Table 1

As it can be seen from Table 1 is too substantial to ignore. It can be concluded that the difference in kind in capital accrual has been changed from a difference in degree in annual return thanks to compounding.

Index funds play a substantial role in the long-term portfolio of investment, so you should carefully study their implications and never forget to take into account costs.

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