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3 Lessons for Index Funds

Due to index funds' portfolios do not exactly match the indexes', on occasion they will sneak past their benchmarks

Index funds did not take the mutual fund industry by storm. Five years after its debut, Vanguard 500 Index had $90 million in assets, which made it a modest sales success by the standards of its time, but scarcely the vanguard of a revolution. Ninety million dollars was also the total of the industry's indexed assets, as neither Vanguard nor a rival had launched a second index fund.

The initial marketing was stymied by the effective, but misguided, claim made by indexing's early critics--that index funds always lose. Every active fund has the chance to beat its costless benchmark. However, index funds are guaranteed to trail. Because they mimic the costless benchmark but then add expenses (and trading costs), they inevitably fail. They lag their benchmarks, every year.

This criticism is largely true, although not entirely. Expenses do indeed drag down the returns of index funds when compared with the theoretical indexes that they track. However, as costs for the big index funds are slight and there is some fluctuation because the funds' portfolios do not exactly match the indexes', on occasion such funds will sneak past their benchmarks.

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About Author

John Rekenthaler, CFA  John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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