Wealth in our Woods Column: Missing the Market

By Kyle Green, CFP®, Sherwood Wealth Management

SHERWOOD, Ore. — Most investors are familiar with Vanguard. It is one of the largest shareholders in many publicly traded companies, owns a significant portion of the U.S. stock market, and manages trillions of dollars in assets. It is also the largest mutual fund provider in the world.

Vanguard was founded in 1975 by John Bogle. While his name may not be as recognizable as Vanguard, Bogle played a significant role in democratizing investing by helping everyday investors participate effectively in capital markets. He was a champion of long-term, low-cost, passive investing and didn’t just argue that point - he built a product that proved it: the index fund.

What is an index fund?

To understand, we need to define two terms.

First, a mutual fund. A mutual fund is a basket of investments bundled together with a particular strategy in mind.

Second, a market index. A market index is a list of companies used to track the performance of a market. For example, the S&P 500 tracks 500 of the largest publicly traded companies in the U.S.

You may see where this is going.

An index fund is a basket of investments built to follow one of those indexes. In other words, it’s a mutual fund that tracks a market, rather than trying to outperform it. This was a core component to Bogle’s philosophy - instead of trying to beat the market, investors should aim to be the market.

Why index funds?

Let’s look at a mutual fund that invests in large, well-known companies that the manager believes can outperform an index, such as the S&P 500. A portfolio manager (or team) chooses the investments - overweighting sectors, adjusting holdings over time, and making decisions based on forecasts and analysis, all with the goal of beating the index. This is active management.

Now compare that to an index fund that tracks the S&P 500. It does not intentionally overweight sectors or forecast market changes. It simply tracks and replicates the index it was created to follow. This is passive management.

The major difference is how the fund’s investments are selected. In an actively managed fund, there are experts making decisions. In an index fund, the process is rules-based and tied directly to the index; there is limited subjective analysis.

Which one costs less?

Index funds - by a wide margin. While costs vary, it’s not uncommon for an actively managed fund to cost 10 to 20 times more than a comparable index fund. The “active” part doesn’t come cheap.  

Beyond cost, index investing can also reinforce good behavior, like sticking with a long-term approach. There are tax considerations as well. Actively managed funds tend to trade more frequently, which can create more taxable events, while index funds are typically more tax-efficient due to lower turnover.

Bottom line: with index funds, you keep more of what’s yours.

What about performance?

Historically, passive index funds have beaten actively managed funds more often than not, especially over longer periods and after costs. While some active managers do outperform, decades of research shows that most do not consistently beat comparable indexes over time. 

In the end, the question isn’t whether some managers will outperform in any given year, because they will. The question is how consistently that can be done, after costs and taxes over a lifetime of investing.

History suggests that it’s a high bar to clear. 

For many investors, a low-cost index approach isn’t about settling for average, it’s about capturing market returns in a disciplined, consistent way. And over time, that consistency can be one of the most powerful advantages an investor has.