Index fund investing is one of the simplest, most reliable ways of building diversified portfolios for your clients. In this piece, we'll define what it is and how it compares to active funds. We'll share tips on how to choose an index fund, with expert insights from one of the most active advocates of index fund investing.
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An index fund is a basket of investments that aims to match, not beat, the return of a market index such as the S&P 500 Index. It can be set up as a mutual fund or as an exchange-traded fund (ETF).
In simple terms, the fund owns the same securities, in roughly the same weights, as its chosen index. If the S&P 500 goes up 10 percent, an S&P 500 index fund will try to deliver close to that return, minus its costs.
"An index fund is a rules-based portfolio that reflects a market or risk factor. It's built on the idea that markets are competitive, costs are certain, and investor behavior is a primary source of underperformance," says Mark Hebner, CEO and founder of Index Fund Advisors. He is also the author of Index Funds: The 12-Step Recovery Program for Active Investors.
"The choice to be a passive investor is also an admission that the market cannot be beaten, other than by luck," Hebner says. "It's a great solution for investors who choose discipline, diversification, low taxes, and humility over prediction."
At a high level, the main difference between index funds and active funds is their goal. Active funds try to beat the market by picking securities and timing trades. Index funds, meanwhile, aim to closely track a market index at low cost.
The sections below break down how passive index funds work, how active funds differ, and why index funds are the ideal choice for long‑term portfolios.
Index fund investing involves matching a stated index as closely as possible (for example, an S&P 500 index tracks the S&P 500). A set of rules is followed, with very little trading beyond rebalancing and index changes.
Because index fund investing takes a passive approach, there are lower expense ratios, low turnover, and lower trading and tax drag.
This all results in a return that's very close to the tracked index, minus a small fee. A few fund managers, most notably Fidelity, offer index funds at zero expense ratio.
Active funds, on the other hand, aim to outperform a benchmark. This is done by choosing specific securities and timing the market. This leads to higher expense ratios, higher turnover, and more taxable capital gains distributions.
The outcome: some managers do manage to beat the market, but this success is short-lived.
The SPIVA (S&P Indices Versus Active) has been measuring the performance of active funds against their indexes for over 20 years. It has found that actively managed funds have underperformed their tracked benchmarks over longer time horizons.
Based on SPIVA's latest scorecard, 88 percent of US large cap funds underperformed the S&P 500 over a 15-year period.
"The basic idea is that market prices reflect available information so well that it is extraordinarily difficult to systematically find mispriced securities," Hebner says, drawing on the efficient market hypothesis. "If prices are already fair, then trying to outguess the market is a losing game on average."
If all this data shows that index fund investing as the way to go, why do some investors still chase active funds?
There's a reason why Hebner's book is subtitled "a 12-step recovery program" – active investing is addictive due to:
Index fund investing, meanwhile, is boring, but in a good way. It's rules based, with data from years of research to back it up.
"An index fund is an excellent and sensible investment for any size portfolio, both for individual and institutional investors," Hebner says.
Index fund investing offers instant diversification, low costs, and a rich history of risk-return data spanning almost 100 years. Nobel laureates like Eugene Fama and experts like Warren Buffett have endorsed index funds as a sensible way to build wealth over time.
A growing number of investors are now onboard with index fund investing. According to a 2024 survey, 45 percent of millennials are into index fund investing, up from 27 percent in 2022.
Before recommending any specific index product, step back and consider how it fits into your client's overall financial plan. The checklist below is a framework you can use to structure, implement, and maintain index fund portfolios on behalf of your clients.
The first step is establishing your client's asset mix. Hebner suggests starting with a well-designed questionnaire covering these points:
These points will help you arrive at a good stock-bond mix for your clients. "For someone with a reasonable time horizon, strong income, and the ability to tolerate drawdowns, a 60/40 mix might be a good starting point. For others, it will be higher or lower," Hebner says.
Following the Fama-French five-factor model, your clients should look at these factors when choosing an index fund:
These help explain where long‑term returns come from and which risks clients are taking on. Being clear about the mix of regions, sizes, styles, and quality factors is the foundation for building a solid index portfolio.
At this point, you can recommend the right allocations based on the points discussed above. "For example, in a globally diversified 60/40 portfolio, you might allocate something like 42 percent of your equity exposure to US stocks, 11 percent to international, and 5 percent to emerging markets," Hebner says.
The goal is to capture broad, rules‑based exposures - across regions, sizes, and styles – without paying for stock‑picking or market timing that rarely adds value over time. In practice, that often means using broad indexes with tilts to small, value, and high profitability stocks.
Keep it simple with bonds, Hebner says. Go for a mix of global and US bonds, with short- and intermediate-term maturity dates. Bond products are meant to stabilize and diversify investments.
Finally, put a disciplined rebalancing process in place. Bring the portfolio back to its target stock‑bond mix and factor exposures, rather than reacting to headlines or chasing recent winners.
"If you follow that checklist – start with your stock–bond mix, choose diversified global indexes aligned with the factor evidence, and commit to a disciplined rebalancing process – you keep your investing passive in the right way and avoid turning it into an active guessing game," Hebner says.
Hebner's firm, Index Fund Advisors, was one of InvestmentNews' top regional fee-only RIAs in 2023. See the complete list of top advisory firms in the Best of Wealth page.
In this article, we looked at the core features of index funds, along with long-term data and insights from an expert like Hebner. Taken together, they make a strong case for index fund investing as part of a solid client portfolio.
For most clients, index funds offer a simple way to capture broad market returns without the guesswork of stock‑picking or market timing. They're especially powerful for investors who want a diversified, long‑term strategy that's grounded in evidence rather than speculation.
Not exactly, but they are closely related. “Index fund” describes the strategy: tracking a market index. That strategy can be wrapped in either an index mutual fund or an index ETF.
Many traditional mutual funds are actively managed. They try to beat a benchmark by picking securities and timing trades.
Index mutual funds are built to match an index, with lower costs and lower turnover.
For clients, the key differences usually show up in expense ratios, tax efficiency and tracking behavior, or how closely they follow the index.
For most US investors, the steps are simple:
Establishing a client’s risk profile is an important first step; the succeeding steps will flow from that.
All investments, including index funds, come with varying levels of risk. But index funds can help manage that risk.
They spread risk over hundreds or thousands of securities, avoid single‑stock blow‑ups and reduce the risk of persistent underperformance from a single manager’s decisions.
For clients with bond allocations, broad bond index funds can help reduce volatility, but they still carry interest‑rate and credit risk.
President Obama’s proposal to raise taxes on affluent households, detailed in his budget plan today, could be a boon for tax-managed mutual funds.
E*Trade Financial Corp. has closed its line of four index funds with liquidations to take place no later than March 27.
Wealth managers in the Phoenix area say that the financial crisis and its calamitous impact on the stock market is forcing them to rethink their investment strategies.
Insurers are eager to continue developing products in the variable annuity arena — with the search for ways to reduce risk as a top priority.
Actively managed equity mutual funds suffered record net outflows of $208.3 billion last year, while equity index funds enjoyed net inflows of $28 billion, according to estimates from Morningstar Inc.
Wash sale rules prohibit an investor from recognizing a loss for tax purposes if securities are sold and "substantially identical" securities are purchased within 31 days.
That, of course, is cold comfort to investors in those funds.
Direxion Shares this week for its first time launched ETFs that have a goal of returning 300% of the performance of their underlying indexes, either on the positive side or the inverse.
A financial advisory firm is betting that investors who use a quantitative formula — rather than emotion and panic — to move in and out of stocks will get through Wall Street's roller coaster ride with their pocketbooks largely intact.
The following edited transcript is from "The Art of Actively Trading ETFs," an InvestmentNews webcast held Oct. 21.
As mutual fund investors brace for a likely double whammy of negative performance, coupled with above-average income and capital gains distributions, financial advisers are homing in on all manner of tax management to try to cushion the blow and add some value in a dismal market environment.
Believe it or not, some presumably sane and sober investors are looking forward to opening their next mutual fund statement.
They may be gaining in popularity, but exchange traded funds are far from the perfect product.
The boom in exchange traded funds appears to have come to an end.
In the biggest shakeout thus far, 25 exchange traded funds already have closed this year, indicating that this fast-growing sector of the fund industry may be settling down.
