It’s more than 45 years1 since Vanguard launched the world’s first index fund for individual investors. These days, index funds hold trillions of dollars, accounting for a significant chunk of all share and bond market investments2.

But what is an index fund? 

And why are index funds, especially low-cost index funds, such a good starting point for investors?

A pooled investment

Let’s start by defining what a fund is and comparing index funds with other types of investment fund – that is, non-index, or so-called ‘active’ funds. 

A fund, in general, is an investment product that pools together money from different investors to buy investments such as shares and bonds. By investing in a fund you gain exposure, in just one hit, to potentially hundreds, even thousands of different companies and many different countries.

Consequently, to adopt a well-known phrase, you don’t put all your eggs in one basket – which is what might happen if instead you invested in individual shares and bonds. 

By pooling resources, funds can also buy and sell shares and bonds more cheaply than individual investors.  

In both these respects, index funds are no different to other funds.

What makes an index fund different

What does make index funds different is how they are put together. Rather than a fund manager deciding which shares or bonds to pick, an index fund aims to closely match (or track) the shares or bonds that make up a specified market index.

Take, for example, the FTSE 100 index that we often hear about on the news, which represents the largest 100 UK companies listed on the London Stock Exchange. Vanguard alone has two different funds that seek to track the performance of this index and, as a result, the collective share-price performance of the companies in the index3

And there are many more such indices and index funds to choose from, each covering different markets, countries and regions – and in some cases, even the entire world. So, with just one investment, it’s possible to spread your money across global markets.

Index or non-index (active) fund?

At this point, you may be tempted to ask: Why settle for the market return? Why not improve on it by putting your faith in a fund manager’s expert judgement, or even your own? 

The reason is simple: Because the evidence shows that it is very hard to beat the market and even harder to do it consistently, which is why many fund managers often fail to do so. 

As the late founder of Vanguard, Jack Bogle, once put it: “Don't look for the needle in the haystack. Just buy the haystack!”

To underline that, experts at Vanguard looked at the performance of all the non-index, or ‘active’, funds invested in shares that were available for sale in the UK over the past 10 years4.

What they found, on a rolling one-year basis and after taking costs into account, is shown in the chart below. The darker line includes funds that were merged or liquidated during the period.

As you can see, non-index funds were on average more likely to underperform their respective benchmarks than not.

Percentage of non-index share funds in the UK underperforming over a rolling 1-year period

Past performance is no guarantee of future results. Notes: Performance is calculated relative to funds’ prospectus benchmarks. “Dead” funds are those that were merged or liquidated during the period. NAV-based performance; returns calculated in British pounds, net of fees with income reinvested. Only funds available for sale in the UK are included.

Sources: Vanguard calculations using data from Morningstar, Inc. Performance is calculated relative to prospectus benchmark, observed from 31 December 2012 to 31 December 2022.

What our experts also found is that this relatively poor showing becomes more consistent over longer periods, as this second chart shows. 

Percentage of non-index share funds in the UK underperforming over a rolling 10-year period

Past performance is no guarantee of future results. Notes: Performance is calculated relative to funds’ prospectus benchmarks. “Dead” funds are those that were merged or liquidated during the period. NAV-based performance; returns calculated in British pounds, net of fees with income reinvested. Only funds available for sale in the UK are included.

Sources: Vanguard calculations using data from Morningstar, Inc. Performance is calculated relative to prospectus benchmark, observed from 31 December 2012 to 31 December 2022.

Why Vanguard offers both index and active funds

At Vanguard we offer both index and actively managed funds. While we are probably best known for our index funds, we also happen to be one of the world’s biggest providers of active funds

This is because we know that some investors, who can tolerate a little more investment risk, may want a mix of both types of funds. 

Even though it is not easy, we do believe at Vanguard that it is possible to achieve investing success with the help of active funds - given the right fund-management talent, a long-term perspective and investor patience.

But this is all the truer if costs are kept down too – which is why we offer low-cost active funds as well as low-cost index funds.

The crucial importance of costs

Still, in general terms, index funds don’t have the added costs associated with trying to identify opportunities that might help them to beat the market – including expensive research capabilities. So there are fewer costs to pass on to investors in fees.

That’s good to know when the evidence indicates that the more a fund costs, the greater its chances of underperforming the market5.  

It’s why low-cost, broadly diversified index funds provide most investors with a great basis for long-term investment success.

To find out more about Vanguard’s range of low-cost index funds, visit our website. 

 

1 31 August 1976.

2 As at 11 April 2023, total net assets held in index funds had an aggregate worth of more than $15 trillion, according to Morningstar, Inc. 

3 This includes an exchange-traded fund or ETF. Incidentally, most ETFs tend to be index funds.

4 For example, Morningstar performed an analysis across its entire universe of funds and found that, regardless of fund type, low expense ratios were the best predictors of future relative outperformance (Kinnel, 2010).

5 Lawrence, Stephen and Dr. Jan-Carl Plagge, May 2023, The case for low-cost index-fund investing, Vanguard research.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Important information

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