The Vanguard 500 index fund (code:VFINX) is, as its name indicates, an Index Funds tracking the Standard & Poor’s 500 index. It was launched in 1976 and has since been a portfolio’s favorite of many investors. Its success boils down to its investment philosophies – and some say its very good customer services.

Vanguard 500 Philosophy

John Bogle, Vanguard founder, built his company and index fund based on his Princeton undergraduate thesis findings. Mr. Bogle used the Standard & Poor’s 500 index to compare the performance of mutual funds in the past. He soon realized that three out of four of the managers were not performing better than a passive investor holding a basket of the 500 largest public companies in America. Their performance were eventually below par as investors still needed to pay their expenses, and active trading incurred taxes.

Mr. Bogle then decided to create a fund following the S&P’s 500 index with extremely low expenses. They achieved those low expenses thanks to a no-load strategy – the buyer do not pays sales commission (also called “load”) when buying or selling fund shares. All this no-load explanation may sound a little complicated. It simply translates into an incredibly low 0.18% expense ratio. Thanks to this sane and sound strategy, the Vanguard 500 Index Fund has grown to become one of the largest mutual funds of any kind. It now has more than $100 billion in assets – and growing!

What does this means to you?

It simply means that the Vanguard 500 is to be present in your portfolio. It is a very safe, cheap, and rewarding fund to hold – for Americans and non-Americans alike. Some may be afraid to invest in American funds right now. They may be right should you consider a lump sum investment. But for those considering cost-averaging, then now is the time to start building your position. What are you waiting for?

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How do they work?

Most of them work like your usual mutual funds; each fund has a price – Net Asset Value – and is traded on a daily basis. They also charge for management fees, trading costs, and may distribute dividends and/or capital gains.

How are they different?

They are considered passive as their manager simply follow the index as closely as possible; they do not try to cherry pick the stocks they hold like usual mutual funds. They do not need to have battalions of analyst to uncover potential hidden gem on the stock markets. Many index funds have little or no human input in the decision thanks to the index they are tracking and the use of computer model to follow them.

What does this means for you?

Firstly, this means that you exactly know what you are investing in when chosing such funds. They are very diversified, and are a very good base to build a portfolio upon as their diversification is very good.

Secondly, your trading costs should be much reduced thanks to low stocks turnover – Indexes do not change on a regular basis, and their components are stable. Striking two birds with one stone, this will also helps avoid capital gains taxes. Their low turnover means that the fund will less frequently need to sell stock to accommodate index changes, saving you the trouble of dealing with these tax liabilities.

Thirdly, thanks to their little human input, the management fees are much reduced – the manager’s job being much simplified. As an example, the Vanguard S&P 500 has a very expensive ratio of 0.1%. You can’t really beat that.

These cost savings can be quite substantial. You can sometimes saves as much as 3 to 5 percent in return per year when comparing with some actively managed funds. Of course you may not have the pleasure to brag about how your portfolio beat the indexes. But you are sure not to have to see your nice double digit returns being eaten up by expensive fees.

Sounds great – but what are the caveats?

Of course, you guessed from the hereabove that I quite like index funds. While I think they are great, you may encounter potential hiccups. What could they be?

First, you will certainly not outperform the market as the funds try to match them. Some discrepancies may happen, but they usually are because of errors in tracking – our second point.

Secondly, some funds don’t track their index as perfectly as you would wish they do. They may take a little time to match changes in their index, or their cash position is sufficient to tamper their performance.

Thirdly, even though indexes are pretty stable, their composition changes over time. As an example a company like Google was not indexed only a few years back. The S&P 500 index has a typical turnover of between 1% and 9% per year. In effect, the fund manager will have to sell its position in markets that fell out of the index and buy the replacing ones so as match the new index.

Finally, following indexes means that you will also enjoy the ups and downs of the tracked index. You will therefore not be fully protected when global market go south. But your diversified investment is a great way to dilute your risks.

At the end of the day…

As said earlier, index funds are great tools to build a portfolio upon. The success of the Vanguard S&P 500 index fund is an example of the investors love for such product. This fund is present in so many investor’s portfolio that it has even more assets under management than Fidelity’s massive Magellan Fund. Quite a statement !