What is an Index Fund? A Wealth Cheat Code!

(Good) index funds are a low-fee, low-effort way to build wealth.

This is part of a continuing series on the basics, where we look at things that probably should have been taught in school if they weren’t so busy having us memorize dates (or dropping out, in my case). While it’s not exactly brief, it’s so critical to the FIRE strategy that I felt we had to go big on this one.

What is an index fund? Put simply, it’s a whole bunch of individual stocks packaged up into one “stock” (or ETF/exchange-traded-fund) so you don’t have to try to pick an individual company. Instead of hoping to find the next Tesla or Apple, you buy an index fund that tracks the entire US stock market (or some sub-segment of it…but keep reading to see why you shouldn’t do that). Basically, you own fractions of a share in every single stock available, content that over time the market will go up. Purchased wisely, it’s also one of the single biggest tools in our FIRE arsenal, allowing us to profit from the rise of the total stock market without worrying about what one particular company is doing (or what its CEO is doing on twitter).

Vanguard – Our Last Best Hope for Investing

Vanguard is an investment firm founded by Jack Bogle, a man known as the “conscience of wall street.” He invented the index fund in 1975 because he saw that individual stocks were too risky and too fussy. As he’s been copied by people hawking “index funds” and ETFs that are really just hyper-niche pools of a few specific stocks, he emphatically believes that those are just distractions designed to take your money via exorbitant fees (known as ‘”expense ratios”).

So while there are many sector-specific and tailored funds available, we’re going to follow the lead of “the conscience of wall street” himself. He believed that while individual companies (and their stocks) may over- or under-perform the market during any given time, the safest and most efficient wat to invest is by (cheaply!) investing in the market as a whole. While hot-shot fund managers may have hot streaks, they must by mathematical necessity eventually revert to the mean ^[1].

What is now the Vanguard 500 Fund started in 1975 as the first-ever index fund. The goal was simple. Rather than pay some suit a huge fee so he can look at his crystal ball to pick winners, buy a tiny bit of each stock listed in the S&P 500. Because it’s so simple and there’s no wall street douchebag with a pinstripe suit in the middle, the costs are drastically lower (you don’t need a fancy gold watch and slicked-back hair to say “there are 500 stocks in the S&P 500, give me one of each”).

Won’t I Get Richer Buying Individual Stocks?

If you have a time machine (or a crystal ball), yes! If you have the foresight to only pick the next Apple, Tesla, Netflix, etc. before they get big, you can have Jeff Bezos bring you coffee every morning. Unfortunately, it doesn’t work that way. Companies rise & fall, scandals happen, and if you’ve ever head of “diversifying your portfolio,” this is the exact reason why. Enron is a household name specifically because so many people (especially employees with company stock options) were heavily invested in that one stock and lost everything when it blew up.

If your entire portfolio consisted of 5000 shares of Enron when it tanked, you went from having to $450,000 to losing everything in a very short period of time. If instead you had 10 shares of each company listed in the S&P500, your portfolio would have dropped a bit and then recovered, following the growth of the market as a whole. Looking at the individual Enron stock from 1997-2002 (really 1997-present, but it’s $0/share after 2002), we have this:

Now here’s the NYSE Composite chart, from 1997-present. You’ll note the 2 red lines are around the same time as the precipitous drops in the Enron chart:

So what if instead of 5000 shares of Enron, you had that same amount of money in an index fund that tracked the NYSE? Instead of being broke after Enron’s collapse, you would have taken a little hit and then kept on truckin’.

Let’s say you had $10,000 to invest on 1/1/2001. If you had invested it in Enron, it would be worth $0 as of early 2002, and that’s it, game over…your entire $10k is gone forever. If you had invested in Vanguard’s Total Stock Market Index Fund, you’d have something like $85,000 as of March 2021.

What About Sector-Specific Funds? 

While the index funds you’ll read about on this site are basically all passive (meaning they buy a weighted amount of whatever stock is in the fund, formulaically without greasy managers), there are more “creative” funds that attempt to target certain sectors. So instead of buying a little bit of every stock in the NASDAQ or the S&P 500, you buy shares of a Real-Estate Investment Trust (REIT) and it has shares of homebuilders, property management companies, real estate developers, etc. Or you buy a fund focused on the automotive sector that just has stock in Toyota, Honda, Ford, GM, etc.

Are you beginning to see the problem? These specialized funds are still essentially trying to pick winners. Maybe not individual companies, but segments of the economy. By buying our imaginary automotive sector fund, you’re saying “I am willing to bet my retirement money that the automotive sector will outperform the stock market as a whole.” You can make a lot of “educated guesses” about why you think that, but it’s still just a bet. There are plenty of wall street types that will take your money to make bets like that:

What About Actively-Managed Funds?

If the broad market index funds like VTI are passively managed, then all of these sector specific or other creative funds need some more attention. Enter the fund managers. People in fancy suits that exist to take your money whether they win or lose. We’ll get into detail about this in the next segment, but take a glance at this 19th-century epigram, quoted by Jack Bogle in one of his later books:

Some men wrest a living with their hands; this is called work

Some men wrest a living from those who wrest a living with their hands; this is called trade

Some men wrest a living from those who wrest a living from those who wrest a living with their hands; this is called finance

The point being…you’re going to work every day, earning money to invest in the market to fund your future retirement. How much of that money do you want to give up to someone you’ve never met, who will take their fees (“expense ratio”) whether their bets win or lose? You may be surprised to learn that the average lifespan of an exchange-traded fund is just 3.4 years*! All these super-niche, actively-managed funds are just complicated ways to get more of your money into some douchebag’s silk-lined pockets. They charge you fees, fold, and move on.

[* note, that’s not to say they go bankrupt and you lose everything, just that the brokers decide it’s not worth the trouble anymore and cash you out…probably around the time people start seeing that the 3-year returns SUCK]

In a future post I’m going to do a deep-dive into Bogle’s thoughts on the stupidity of actively-managed funds, but for now let’s look at the fruits of his labor (blindly tracking the market as a whole and doing so for minimal cost).

What are those fees costing you?

In the table below, we’ll look at how expense ratios would impact a theoretical $10,000 investment for 10 years in an imaginary fund that returned 6%.

fee	notes	end amount	cost of fees
.03%	actual expense ratio of Vanguard’s VTI	$17,857	$50
.34%	actual expense ratio of iShares REIT	$17,342	$566
1.3%	actual expense ratio of CreditSuisse REIT	$15,829	$2,079

While a fee of .34% (or maybe even 1.3%) might not *seem* like a ton of money, over the long run it really adds up. In that 10-year term our $10,000 could have grown to $17,908 with no fees at all, but you can see how much we’re giving away to fund managers above.

For added drama, let’s look at a more realistic FIRE scenario. Say you have $500,000 invested already, and you’re going to sock away another $50,000/yr over the next 10 years so you can retire in luxury. How would index funds treat you then? Looking at the same 3 examples:

fee	notes	end amount	cost of fees
.03%	actual expense ratio of Vanguard’s VTI	$1,590,294	$3,711
.34%	actual expense ratio of iShares REIT	$1,552,435	$41,570
1.3%	actual expense ratio of CreditSuisse REIT	$1,440,779	$153,226

The Takeaway

In the table just above, you can see how even a relatively “modest” fee can cost you tens or hundreds of thousands of dollars. Since no one (not even the slickest fund manager) has a magic 8-ball, and over time any funds must naturally revert to the mean, the best way to maximize your return is to park your money in the mean itself for the lowest fees available. In pretty much every case, that means a broad passive index fund like Vanguard’s VTI/VTSAX.

If you believe in the long-term growth of the stock market as a whole, you don’t need to pick winners, just pick the market itself and pay as little as possible for the privilege.

Bonus Feature: Warren Buffet Bets on Index Funds (Literally)

In 2008, Warren Buffett (the “Oracle of Omaha” and possibly the only other old rich dude besides Jack Bogle that you could trust with your money) made a bet. He wagered $500,000 (for charity) that investing for 10 years in a simple Vanguard index fund would outperform any hedge fund of anyone’s choosing (see page 22 of his annual report for details).

Essentially nobody took the bet. Hedge funds that rake in millions and billions of dollars of fees were unwilling to bet on their own operations against a passive index fund. Finally, Protégé Partners took him up on that. They chose 5 “funds of funds” that were collectively invested in over 100 different hedge funds…operations that exist solely to take your money because they can “beat the market.” You can see in the chart below how that worked out. Over 10 years, only one of the hedge funds came within 25% of a simple Vanguard index fund, and most were just abysmal:

Now not all of that is due to fees, some of it just that hedge funds can’t pick winners any better than you can. Still, he estimates in some of the funds a total of 60% of the gains made went to various levels of managers. For worse results than you could get by just parking your money in a Vanguard index fund and nobody (including Vanguard) thinking much about it.

[1] Buffett summarizes the concept of “it’ll always revert to the mean” this way:

If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe,
and B is destined to achieve average results before costs, so, too, must A.

Whichever group has the lower costs will win.

What’s the stupidest exchange-traded fund you’ve seen?