The investments included in a given index are generally published openly, thereby making it easy for an index fund to track its respective index. (All the fund has to do is buy all of the stocks — or other investments — that are included in the index.) As you can imagine, implementing such a strategy can be done at a far lower cost than that charged by the average actively managed fund.

Common sense (and elementary school arithmetic) tells us that:
◾If the entire stock market earns, say, a 9% annual return over a given decade, and
◾The average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,

…then the average dollar invested in the stock market over that year must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that sought only to match the market’s return, while incurring minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors.

It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Taxes Are Costs Too. If you’re investing in a taxable account (as opposed to a 401(k) or IRA), index funds can help you not only to minimize costs, but to minimize taxes as well. With mutual funds, you pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

Because most active fund managers buy and sell investments so rapidly, a large percentage of the gains end up being short-term capital gains. Because short-term capital gains are taxed at your ordinary income tax rate (as opposed to long-term capital gains, which are currently taxed at a maximum rate of 20%), you’ll end up paying more taxes with actively managed funds than you would with index funds, which typically hold their investments for longer periods of time.