How to understand indexing basics - Vanguard

Catherine Gordon: Perhaps you've heard about index mutual funds but need to know a little
more before choosing this type of investment. Let's take a look at how they work to see
if index investing is right for you.
An index fund seeks to chart the returns of a certain market segment or benchmark, such
as the Standard & Poor's 500. Index funds hold the same securitiesóor a representative
samplingóas the index. They may consist of stocks, bonds, or other securities, but the
goal is the sameóto produce returns based on the performance of that fund's index.
So why would you consider choosing an index fund over other investments?
The answer is pretty simpleódiversification at low cost. Index funds typically have lower
costs than actively managed funds because they're Ö well, not actively managed.
Since the fund simply seeks to chart a particular index, it doesn't have to pay a fund manager
to constantly buy and sell securities to try to beat the market. Lower costs mean more
of the returns are passed on to you.
So if you assume a level playing fieldóan index fund versus a similar active fundóthe
index fund probably is going to be ahead of the game.
There are other benefits to index investing. There's less turnover of securities in index
funds, so they generally distribute fewer taxable gains than active funds.
Less turnover also means less guesswork, since you'll have a good idea of which securities
the fund contains. And less guesswork just might mean you can spend less time choosing
a fund and more time tending your garden or watching the ballgame.
It's not that there aren't good actively managed funds out there, but an index fund takes a
simpler approach.
It's also important to note that all index funds are not created equal. Many investment
companies charge a sales load or other fees to buy index fund shares. And buying them
through a broker probably will cost you a commission for the trade.
Certain index funds run the risk of tracking error, when the fund's return differs from
its index. This can be caused by many factors, including the fund's expense ratio or transaction
costs. These are good reasons to choose a fund from an investment firm that has experience
and expertise with the "ins and outs" of indexing. It's a profession, not a hobby.
You might ask: What's the best way to get started with indexing? A good first step would
be to look for a fund that seeks to track a total market index, be it stocks, bonds,
or a combination of both.
You also could consider owning an exchange-traded fund that seeks to track an index, though
you may pay a commission to buy or sell an ETF.
And just as a single mutual fund diversifies your investment dollar, there's nothing wrong
with owning active funds to complement your index holdings.
It's not that there aren't funds with managers who sometimes beat the market, but it takes
a lot of time, effort, and research for them to do so. Somebody has to pay for this, and
it'll probably be the fund's shareholders.
Look at it this way: The actively managed market is like a good action movieówhere's
the market moving; what's the next IPO; who has the hot stock, and so on. It might be
exciting, but it also might be a little tougher to stomach.
So while indexing may seem to be a yawn, it does mean the fund will always seek to provide
the full market return, minus expenses.
And ultimately, low expenses are a good way to differentiate among funds. That's why we
think that indexing is the investment professional's option for the nonprofessional investor.
You can learn more about indexing at Vanguard.com, including how to compare index and active
investing.
Thanks for watching.