05/10/2013 11:11 am ET | Updated Jul 10, 2013

A Primer on Index Funds

Questions that inevitably always arise in my Introduction to Investments (ECO/FIN 112) classes are: "What do I need to do in order to beat the stock market? How can I select the 'winners?' What is the most important variable when researching a particular company?" Etc. In response, I always reference the Efficient Market Hypothesis (EMH). The definition is as follows: "... all relevant information is fully and immediately reflected in a security's market price..." This statement essentially implies that no stock is undervalued or overvalued, and more importantly proclaims the futility of an investor being able to consistently earn gains greater than overall market returns after adjusting for risk. The reasoning behind the EMH alludes to several factors, namely: (1). There exists a large number of competing market participants (investors), (2). Financial information is easily available and relatively inexpensive to obtain (i.e. the internet), and (3). Transactions costs (fees incurred when buying and selling shares) are minimal. Obviously as the lesson progresses, my students' expressions appear decidedly more and more dejected. "Do not fear!" I tell them, there is indeed a way to beat this efficient market.

Even if acute security analysis (there are two types: fundamental analysis - scrutinizing a firm's financial statements which are what the majority of Wall Street Analysts do, and technical analysis - examining a stock's past price movement in search of future patterns) would provide abnormal investment profits in the long run, most of us wouldn't have the time or energy to engage in the rigorous research required. Thus we end up handing over the reins of our financial futures to "financial advisers" and/or "money managers." However impressive the track record of these asset management gurus may be, empirical research has repeatedly revealed that the majority of investment funds that are "actively managed" have yielded lower long-run returns than non-active (or passively) managed funds. Besides the decree touted by EMH, the other primary culprit are costs. Actively managed funds tend to charge anywhere from 2 to 4% annually, sometimes even higher. This is a huge impediment to anyone's retirement portfolio returns. Why the hefty charges? These managers are being "active" in the sense that they are constantly shuffling (i.e. buying and selling) around various securities within your fund in their vain attempts to "beat the market." If we look at the investment funds that have earned returns greater than the market return for a certain period of time, the end results have generally shown that something that is indeed to be good to be true usually is (see Bernard Madoff).

What is the alternative? Enter index funds - almost cost-free, passively managed funds first brought into existence by The Vanguard Group founder John C. Bogle in 1975, the same year Vanguard was founded. Bogle had done research into mutual fund returns and discovered that about 75% of funds did not yield higher returns than the S&P 500 (an index of the 500 largest U.S. companies by market capitalization) as a whole. In other words, three out of every four asset managers who devoted their careers to finding ways to "beat the market" by selecting specific stocks within the S&P 500 were left worse off than if they owned all 500 of them at once. Thus Bogle introduced what was a radical idea at the time: a "no-load" (non-commission) fund which would mimic the returns of an entire collection of stocks at virtually no cost. Bogle's initial index fund was the Vanguard 500 index, which essentially mirrors the S&P 500. The fund has averaged an 11% return annually since its inception in 1976.

Presently, most investment management firms offer a plethora of index funds that are sorted by various characteristics including industry, market cap, and dividend yield, to name a few, and charge annual fees as low as 0.16%. The thinking behind investing in index funds is appealingly simple: it is impossible to "beat the market", so why pay a so-called professional to do so? As I tell my students at the end of the lesson, in addition to the importance of being conscientious regarding one's long-term investment goals and risk/reward preferences (i.e. how much risk one is willing to suffer for an investment's potential gains), index funds truly are the ultimate low-cost, low-risk method for beating an efficient market.