Index Funds Can Beat The Market, Here’s How…

Posted on November 15, 2013 at 11:02 AM PDT by

It sounds a little crazy at first blush, but index funds can beat the market if you use them the right way.

Not just any single index fund, naturally. As you might expect from the name, index funds are designed to faithfully track the market itself.

They do so at rock-bottom cost. If you buy an S&P 500 fund that is built to index the market, you can expect to get that return, minus an extremely low fee. The Charles Schwab U.S. Large-Cap ETF (SCHX), offers an expense ratio of just 0.04%.

index funds can beat the market

Let’s compare that to a typical large-cap mutual fund. Picking one out of the hat, consider the T. Rowe Price Equity Index 500 Fund (PREIX). It has an expense ratio of 0.28%. A decently run product at a reasonable price, for sure.

Over the past three years, the Schwab fund has returned an annualized 16.51% (October number) and the T. Rowe mutual fund 15.96% (end of September). Run that through the FINRA fund analyzer and you find that the difference in total fees is considerable. On a $100,000 investment earning a market return, the fees for the Schwab fund come to $1,688 and for the T. Rowe product it’s $11,479.

The gap in return is even higher. Because of lost compounding, you leave $17,990 on the table with the pricier fund.

Okay, you might say, I’ll buy the inexpensive ETF. But even with the cheaper fund I’m still out a decent-sized mortgage payment in terms of the fees. I can’t beat the market that way, right?

Ah, but yes you can, if you mix up a selection of index ETFs in a well-diversified portfolio. Burton Malkiel, the Princeton professor and author of “A Random Walk Down Wall Street” figures the simple act of rebalancing gave ETF portfolio investors a 1.5% bump over the stock market over the past 15 years.

Yes, index funds can beat the market

Morningstar shows the S&P 500 returning 7.67% annualized over the past 10 years. Your $100,000 investment over 20 years at that rate of return becomes $456,984.

Add on Malkiel’s extra 1.5% and the numbers change. Earning 9.17%, your initial investment turns into $613,060. Let it run 10 more years and that single investment is now worth well north of $1.5 million.

Past performance is meaningless, of course, but a balanced collection of diversified, low-cost ETFs is by no means a wild ride. Instead, steady compounding and periodic rebalancing help smooth out the rough patches in the markets while building real wealth.

Rocket science? Hardly. But it is discipline, saving and prudent investing — and making sure you get the most bang for your investing buck, year after year.