What are the advantages of indexing?

Index investing—through ETFs or mutual funds—can offer several significant benefits.

 

Low costs

Index funds have a powerful advantage over most actively managed funds—lower costs. Here are two main reasons:

• Lower total expense ratios (TERs). It simply costs less to manage and operate an index fund. That's because index funds don't have to employ highly paid teams to analyze and select stocks.
• Lower transaction costs. Index funds use a buy-and-hold approach, which means that index fund managers generally trade securities less often than active fund managers. Less trading reduces brokerage commissions and other expenses associated with trading securities.

 

Figure 1. The annual cost of a $100,000 investment

Source: Data is comprised of index and active funds and ETFs registered for sale in Mexico. Vanguard calculations using data from Morningstar. Data as of May 31, 2016.

 

Diversification

We believe maintaining a diversified portfolio is an essential part of a successful investment plan, and indexing can be a simple way to achieve diversification. It's difficult for actively managed funds to compete with index funds when it comes to diversification relative to a specific market segment. That's because index funds generally hold most or all of the securities in their target indexes.

 

Figure 2. Average number of securities held

Source: Data comprises index and active funds and ETFs registered for sale in Mexico. Vanguard calculations using data from Morningstar. Data as of May 31, 2016.

 

Competitive performance

Thanks to their diversification and low costs, index funds can be an effective way to achieve competitive returns over the long run.

 

Transparency

There's nothing complicated about how index funds are designed. They have a precise, easily understood objective: to track the performance of a specific index (before fees and expenses). With index funds, you always know how your money is invested.

 

Low manager risk

Index funds virtually eliminate the exposure to manager risk. That's because they seek to track, not outperform, a market index. Active fund performance, on the other hand, is subject to more uncertainties.