If you haven’t heard of index funds, then you haven’t been paying attention. Even billionaire investor Warren Buffett says most people should be investing in index funds. Not only is Warren Buffett correct, he is so correct that the S&P 500 so far this year has outperformed his own highly experiences stock pickers year to date. Thats right, you as a little investor can get Warren Buffett performance without the hassle of picking stocks or paying exorbitant fees for the privilege.

If you are new to the index game, let me explain how it works. As an example I am going to use the SPX. The Standards and Poor 500 is an index of 500 or the largest stocks in the world. They include companies like Walmart, Google, Chase Manhattan Bank and Boeing. All an index fund does is try and mimic the index as close as possible. This includes component companies and their weighting in the index. But lets not try and get to technical. Mainly, when you purchase an index fund, you are participating in an index, and all the manager is doing is trying to follow the index as close as possible as cheap as possible. So how does it do this?

Size and Scale are Key

IF you look at most index funds, they are massive. They are also normally run by large fund companies. The three biggest being Vanguard, Fidelity and Charles Schwab. The Charles Schwab S&P500 Index fund is around $36 billion in size. Yes, billion with a B. And they are the smallest of the three I mentioned with Vanguard being 438 Billion, and Fidelity being 183 billion at the time I am writing this post. So yes, they are big. But their size is exactly what they need to achieve the low costs you want. As you can imagine, spreading out the cost of portfolio managers, traders and overhead across a larger base means lower costs.

Easy Management

Index funds don’t need investment analysts, they don’t need to decide what funds stay and what ones leave. All they need to do is invest all their cash into the index as cheap as possible. So there are not expensive analysis platforms, flights to meet with CEO’s or industry specialists. All they need are really good traders to get the funds invested as quickly and efficiently as possible. And what most people don’t realize, is they don’t just buy stocks with it. When the pricing is right, they will also purchase futures contracts when they think it’s cheaper than the underlying stocks instead.

Soft Dollars

Soft dollars have a bad connotation in the markets because they can be abused. But the soft dollar arrangements for an index fund can be completely different than the soft dollar arrangements for actively managed funds. In a soft dollar arrangement, a fund directs trading to particular brokerage firms in return for benefits. Many times with actively managed funds its research, but with an index fund, it could be used to pay for things like Bloomberg terminals and other technology. And because the volume is so huge, it gives the fund a lot of leverage in executing trades.

Securities Lending

Almost every index fund practices security lending and in many cases, when executed right, can mean at times, the index fund actually outperforms the actual index. But what is securities lending. Like the name says, the fund lends out securities. But who is borrowing it?

If you ever watch CNBC or read the Wall Street Journal, you will read about hedge funds and activist investors betting against specific stock. They normally do this by shorting stocks. So how does this work? Lets say investor A thinks that the Stock of Apple is going to go down. Obviously if they thought it was going up, they purchase it, wait for it to go up, then sell when it does. But if they want to bet its going down, they borrow shares from someone else, sell them, and then when the stock price (hopefully) goes down, they buy them back at the lower price, and returns them to who ever they borrowed them from.

As you can imagine, index funds are a great source for borrowing those securities since they have so many. And those index funds don’t lend those securities for free. In fact they charge a fee for doing the lending but also get collateral equal to slightly more than the value of what they are borrowing. So not only do they get the fee for lending, but if they are also the lending broker, they can invest the collateral for additional return. This is how Fidelity Investments was able to provide index funds without a management fee. Not only do their funds lend but Fidelity is a large equity dealer as well.

This is why you should use Index Funds

What most people don’t realize is that the returns that mutual funds post, are before management fees. So if an actively managed mutual fund has a 1% management fee, their 8% return they are showing, is actually only 7% since you have to pay after the returns. That is why an index fund like those above are so valuable, is what you are paying to manage them is a fraction of the cost. And with that you get access to professional managers, traders and you don’t have to worry as much about computerized trading algorithms messing up your returns. If you are not using index funds, I recommend you look at them.

I know most people like Vanguard but I personally use Fidelity and Charles Schwab. Not only is their technology better, but their fees are lower and Vanguard charges a fee if your funds are to low. And both those companies have no minimums and no fees so there is no reason not to get started today.