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The MotleyFool IndexFunds

The MotleyFool IndexFunds

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Published by John Budnik
An article by Motley Fool on Index Funds.
An article by Motley Fool on Index Funds.

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Published by: John Budnik on May 28, 2008
Copyright:Traditional Copyright: All rights reserved

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06/14/2009

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The Motley Fool: Print Articlehttp://www.fool.com/Server/printarticle.aspx?file=/mutualfunds/inde...1 of 24/10/08 2:57 PM
Previous Page
Index Funds | Index Mutual Funds | Investing in Index Funds
http://www.fool.com/mutualfunds/indexfunds/indexfunds01.htmMany stock investors turn to thelettersWarren Buffett, CEO of Berkshire Hathaway (NYSE:BRK.AandB), writes every year to Berkshire's shareholders for some of the most valuable stock investing lessons availableanywhere. But mutual fund investors have their own Buffet in John Bogle of the Vanguard Group, whoseCommon Sense on Mutual Fundscontains a distillation of facts, figures, and analysis on mutual funds and arethe most comprehensive and useful education that a mutual fund investor can acquire. Fools are certainlyindebted to John Bogle, for showing clearly that -- contrary to what you may have read on countless magazinecovers -- mutual fund investing is extremely simple: Buy an index fund.(Psst. There's a reason that all these magazines don't tell you how simple mutual fund investing really is.Scientific marketing surveys and focus group testing have determined that magazines with covers that read"Index Funds: Still The Best Choice!!!" every single month really wouldn't sell as well as magazines that promise"Our BRAND NEW 10 Best Mutual Funds To Buy RIGHT NOW!" Sad, but true.)In 1975, John Bogle presented an idea to the board of directors of the newly formed Vanguard Group -- createan extremely low-cost mutual fund that would not attempt to beat the returns of the stock market as measuredby Standard & Poor's 500 index instead, it would attempt to mirror the index as closely as it could by buyingeach of the index's 500 stocks in amounts equal to the weightings within the index itself.In his presentation to the Vanguard board, Bogle presented the historical data then available to him. In hisaccount of The First Index Fund, Bogle writes:"I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per yearin transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an indexfund should reasonably be expected to provide an annual return of +1.5% above a managed fund."In the intervening years Bogle has proven to be even more correct about indexing than he had predicted hemight be. Since then, the gap between the performance of the market and the performance of activelymanaged mutual funds taken as a whole has actually been significantly wider than the 1.5% theorized by Boglein 1976. During the 1990s, the total shortfall between actively managed mutual funds and the market asmeasured by the S&P 500 has so far been a whopping 3.4% per year.The differential between actively managed funds and passively managed index funds is very easily explicable.The difference does not come from the actively managed mutual funds being run by buffoons. Not at all. Thestocks that mutual fund managers pick end up being more or less average performing stocks. Bogle analyzesthe differential as being determined by four factors:
costs, turnover, sector,
and
cash reserves.
During the 1990s, the S&P 500 has provided an annualized return of 17.3%, compared with just 13.9% for theaverage diversified mutual fund. This 3.4% is explained first by understanding the fact that during the 1990s theS&P 500 (essentially an index of the 500 largest companies in America) has produced returns that are betterthan the rest of the market. One must first look at an index of the whole stock market, the Wilshire 5000 Index.The return for the Wilshire 5000 has been 16.3% during the 1990s, so you should count 1.0 percentage pointsas a "large-cap effect," bringing the gap between managed funds and the Wilshire 5000 down to 2.4%.The
expense ratio
of the average fund, that is the average amount of expenses that a fund charges itsshareholders every year, was about 1.3% during the period. (Over the last couple of years expense ratios havebeen rising further and currently stand at 1.5%.) By comparison, the Vanguard S&P 500 expense ratio is 0.19%.

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