FOR MANY INVESTORS -- particularly young ones just starting out -- index funds are by far the
easiest, most effective way to go. They have the lowest fees, they are tax efficient and you don't have
to worry about what the fund manager is doing. If your goal is long-term growth without having to pay
much attention, these workhorse funds are the best solution.
How do they operate? Technically, index funds do have fund managers, but they don't do a heck of a
lot. They simply buy all the stocks or bonds in a chosen index with the goal of matching that group's
performance. What's an index? It's a grouping of stocks chosen to represent a certain market segment.
The S&P 500 index, for instance, is comprised of large stocks. The Nasdaq Composite index is heavy on
technology companies. By purchasing either index, a fund tries to mimic the returns of that particular
segment. (See our Stocks course for more on how stocks behave.)
Sounds boring, but it works. Consider the Vanguard 500 Index fund. By the end of 1998, it had become
the second biggest fund in the world -- with $74 billion in assets -- largely because investors flocked to
its exceptional 24% five-year annual return. By merely mimicking the S&P 500, it beat 97% of the
"active" fund managers out there over the same period.
A really good fund manager should be able to beat the index. But index funds have another advantage:
low expenses and tax efficiency. Since the fund manager doesn't have to look actively for stocks, these
funds are relatively cheap to run. And low turnover limits tax liability (see Cost Control). The Vanguard
500 Index fund, for example, has an incredibly low annual fee of 0.18% of your investment. An average
large-cap fund like SunAmerica Blue Chip Growth can charge more than seven times that much.