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Index funds are more popular than ever—here's why they're a smart investment

Twenty/20

U.S. stock index funds are more popular than actively managed funds for the first time ever, according to investment research firm Morningstar. As of August 31, these index funds held $4.27 trillion in assets, compared to $4.25 trillion in active funds.

Index funds were created by Jack Bogle almost 45 years ago as a way for everyday investors to compete with the pros. They're designed to be simple, all-in-one investments: Rather than picking stocks you or your fund manager thinks will out-perform the market, you own all of the stocks in a certain market index, like the S&P 500 or the Dow Jones Industrial Average.

The thinking isn't that you'll beat the market, but rather that you'll keep up with it. And considering that the stock market has historically increased in value over time, that pays off for retirement investors.

Index funds have turned out to be a huge win for retirement savers and other non-finance professionals for many reasons. First, because you're not paying someone to pick stocks for you anymore, index funds tend to be less expensive for investors than actively managed funds: The average expense ratio of passive funds was 0.15% in 2018, compared to 0.67% for active funds, Morningstar reported. The original index fund, the Vanguard 500, has an expense ratio of just 0.04%.

Index funds also typically make trades less often than active funds, which leads to fewer fees and lower taxes.

Consistently buy an S&P 500 low-cost index fund. I think it's the thing that makes the most sense practically all of the time.
Warren Buffett
CEO of Berkshire Hathaway

"Costs really matter in investments," investing icon Warren Buffett told CNBC in 2017. "If returns are going to be seven or 8% and you're paying 1% for fees, that makes an enormous difference in how much money you're going to have in retirement."

Second, index funds tend to perform better over the long term than actively managed funds, making them ideal for people investing for retirement. It's incredibly hard for a person to pick stocks that will beat the market and even harder to do so consistently over decades.

In fact, the majority of large-cap funds have under-performed the S&P 500 for nine years running. "While a fund manager may outperform for a year or two, the outperformance does not persist," CNBC reported. "After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index." Large-cap funds are made up of the publicly traded companies with the biggest market capitalizations.

Where active funds theoretically have a leg up is during periods of market volatility. The theory is that the managers will be able to shield their investors from some of the market's deviations. But that wasn't the case in 2018, for example, when managers still under-performed indexes, despite a rocky fourth quarter.

For the everyday investor looking to build wealth long term, that all adds up to make low-cost index funds a go-to investment.

"Consistently buy an S&P 500 low-cost index fund," Buffett said. "I think it's the thing that makes the most sense practically all of the time."

Don't miss: Why Warren Buffett says index funds are the best investment

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