On Wednesday's episode of the long-running game show "Jeopardy!", all three contestants, including Amy Schneider, who is, as on January 6, on a 26-game winning streak, found themselves stumped. The category was "Hand-y Responses." The clue: "An investment fund with a portfolio that tracks a group of stocks such as the S&P 500 companies."
The correct response, host Ken Jennings told them, was "index funds." (Get it?)
Just because no one rang in doesn't mean that none of the contestants know what index funds are. It's more likely they drew a blank. During my 2019 appearance on the show, neither my opponents nor I could summon a Crayola shade of purple named after a flower. My brain went to lilac and lavender but couldn't find its way to violet. Being on TV is weird, friends.
Still, if you were shouting the answer at your screen, you probably weren't alone. After all, investments that track an index currently hold some $20 trillion of investor cash in them, and your workplace retirement plan is virtually guaranteed to offer one.
So, if you think you would have snagged the $1,000 clue over champ Amy Schneider, enjoy the moment. And if you didn't know what on Earth Ken was talking about, read on for a quick refresher.
In general, mutual funds and ETFs come in two flavors. Actively-managed funds are helmed by managers who make trades and calibrate the fund's portfolio in an attempt to outperform a particular market index.
The problem with that approach, according to Warren Buffett and a litany of other market observers, is that consistently beating the market is difficult, and very few professional investors can do it.
That's where index funds come in. These mutual funds and ETFs aim to replicate the performance of a particular index rather than trying to beat it.
Over the long-term, investors in these funds have tended to come out ahead. Over the 10-year period ending in June 2021, just 25% of active funds achieved higher returns than passive funds tracking the same indexes, according to Morningstar.
Part of index funds' return advantage can be chalked up to what investors pay for them. Because there isn't an active manager running the show and collecting a hefty salary, index funds charge very little in the way of management fees.
Over time, the fees you pay to own a fund, typically expressed as a percentage of the fund's assets you owe on an annual basis and known as the expense ratio, can eat into your returns.
Video by Courtney Stith
The average passive fund charges 0.12% in expenses, compared with 0.62% for the average active fund, according to the latest Morningstar data. Say you invest $10,000 into funds with those expenses and earned an average annual return of 8% over the next 40 years. At the end of the period, passive investors would have about $207,000, having paid about $3,000 in fees.
Fees for active investors would total more than $14,000, bringing their total to about $169,000, despite the fact that the fund earned the same return.
If you're building a portfolio from scratch, index funds provide a low-cost way to broadly diversify your investments. And spreading your bets around different kinds of investments is important to your long-term returns.
Different types of investments perform differently under different market conditions. Take a look at investment firm Callan's Periodic Table of Investment Returns to give yourself an idea of how often different horses take the lead in the proverbial race.
By investing in a broadly diversified portfolio, you give yourself a good chance of having some money in what's working while limiting the probability that your portfolio will take plunge should one particular type of investment take a nosedive.
Video by Courtney Stith
Index funds are one of the cheapest and easiest ways to access broad diversification. Investing in a total market index fund, for instance, gives you exposure to 97% of investable U.S. market cap, giving you access to companies of all sizes.
From there, experts say you can branch out by adding funds that cover broad swaths of the bond market or ones that invest in a wide array of international stocks.
"Those three types of funds, for a lot of investors, can form a perfectly suitable portfolio," Ben Johnson, director of global ETF research for Morningstar, told Grow. "It's like a simple, three-ingredient cocktail that you can pour into your shaker, mix the portions you want, and at the end of the day it will do quite well for you."
More from Grow: