Money Essentials

Benefits of index funds

The pros and cons of using - or not using - index funds.


With the best business schools in the country churning out a steady supply of expensively educated MBAs who go to work for fund companies, you'd think funds would have no trouble posting above-average returns.

After all, fund shareholders (that's you) are paying fund managers big bucks to find the best stocks in the market.

The fact is, however, a majority of funds don't beat the market in most years. That is, you're better off buying all the stocks in the Standard & Poor's 500 index or in the Wilshire 5000 index (which includes just about every stock on the New York, American, and Nasdaq stock exchanges) than paying someone to select what he thinks are the best ones.

There are several reasons so many funds fall short.

First, factor in investing costs that fund companies incur - the cost of research, administration, managers' salaries, and so on.

That cost is borne by the shareholders and gets deducted from returns. A fund manager needs to pick a lot of great stocks to make up for those costs.

Index funds, meanwhile, are much lower maintenance and tend to have much lower costs.

There are some caveats. Indexing seems to work better in some areas than others. The case is most solid for large U.S. stocks and bonds, largely because there is so much information on these big securities that it is tough for a fund manager to gain an edge.

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