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- Index funds are financial vehicles that pool investors' money into a portfolio of securities that mirror a particular market index.
- Because they are passively managed, index funds have low fees.
- Diversified by design, index funds are relatively low-risk, but their gains tend to be slow as well.
If you're looking for a low-cost, low-risk investment vehicle for long-term, passive investing, index funds are the way to go. Index funds can help diversify your investment portfolio by mimicking a particular financial market index. That said, there are still some risks to consider before investing.
Here's everything you need to know about index funds.
What is an index fund?
An index fund is a mutual fund or an exchange-traded fund (ETF) that pools investors' money to purchase a portfolio of stocks, bonds, or other securities. This portfolio is designed to mimic a particular financial market index — a select group of securities.
Index funds differ from other funds based on their investment strategy. This strategy is to follow its benchmark — or designated market index — generally, a broad-based one that tends to perform well over time.
How index funds work
When you invest in index funds, you're buying shares in all the companies that make up the index. Most index funds are weighted by market capitalization — the total dollar market value of a company's shares. That means that these funds usually purchase more of the largest companies in the index than of the smallest companies.
The composition of the benchmark index determines the trading decisions of an index fund. By design, true index funds must follow their index. That means there is no room for fund managers to make decisions about which trades to make. Rather than actively picking stocks, they are practicing passive management.
Many different indexes are tracking different sectors of the market. Along with the well-known S&P 500, others include:
- Dow Jones Industrial Average (DJIA), which is made up of 30 large-cap companies
- Russell 2000 (RUT), which consists of 2,000 small-cap stocks
- Bloomberg Barclays US Aggregate Bond Index, (LBUSTRUU), which consists of bonds
- MSCI EAFE (MXEA), which is made up of foreign stocks
- New York Stock Exchange Composite Index (NYA), which includes all common stocks listed on the NYSE
Index funds are also referred to as "passive funds" or "passively managed funds."
Some funds, called "active index funds," largely follow an index but also allow the asset manager to choose to buy certain other individual stocks or sell others.
These are not true index funds because they do not necessarily follow an index. Over time, the portfolio of these funds may differ significantly from the index the fund purportedly follows.
Index funds: Pros and cons
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Many investors, especially beginners, prefer index funds to stocks for plenty of reasons. The main benefits of index funds include:
1. Diversification means you'll usually win
SPIVA's 2022 scoreboard found that 63% of mid-cap funds underperformed and 57% of small-cap funds compared to their benchmark index (that is, the segment of the market they loosely follow).
And if a problem for the pros, imagine what it's like for the amateur investor. "Trying to pick winners, for most, is a loser's game," says Robert R. Johnson, professor of finance at Creighton University. "The solution is to invest in diversified funds."
An index fund provides you with a diversified portfolio of stocks that, as a group, usually do well over time. For example, the Vanguard 500 Index Fund (the one that started it all) has seen a 5-year average return of 11%.
2. They are cost-effective
Diversification can be expensive to pursue by yourself with individual investments. Index funds offer more bang for the buck — a single purchase into its pooled portfolio makes your diversification more cost-effective. Some funds have minimums as low as $0.
3. They are passively managed
Many casual investors aren't interested in managing their investments; they just want to steadily grow their money. Index funds don't require any decisions, so they're great for hands-off investors.
4. They have the lowest costs and fees
Index fund managers don't make any investment decisions, so they don't need to hire researchers or analysts. Those cost savings are passed on to investors through lower management fees and costs. For example, the average expense ratio of an index fund may be up to 0.49% or as low as 0.03%.
Cons
Index funds also come with disadvantages and risks:
1. They're not great for short-term gains
A diversification strategy limits how much you lose if a single stock tanks, but it also limits your opportunities to gain on well-performing stocks. That's why index funds don't see the big upswings that some investors are hoping for.
If you're looking to speculate on a skyrocketing star, you'll want another type of product (perhaps penny stocks).
2. They're vulnerable to the market
By their nature, index funds are tied to their index. If the benchmark is dropping, so will the value of your index fund investment.
And management's hands are tied. "Index portfolio managers typically can't deviate from the index holdings—even to take advantage of trends or market mispricings," says Tricia Rosen, CFA and principal at Access Financial Planning. "And they can't exclude holdings that are over-valued, either."
3. They may not be as diversified as they appear
Brian Berkenhoff CFA and founder of Birch Investment Management notes that "an investor who has $1,000,000 in an S&P 500 index fund would seem to be diversified by owning 500 stocks. However, because most index funds weight investment by market capitalization, $220,000 of that might be invested in just five companies."
Case in point: The top five companies in the S&P 500 are Apple, Microsoft, Amazon, Nvidia Corp., and Alphabet — all players in the tech sector. So if that sector tanks….
Types of index funds
Broad market index funds
Broad market index funds attempt to mirror the total performance of an asset class in the stock market, such as stocks, bonds, and other securities. This way investors can benefit from the exposure to multiple market sectors across various market caps.
Some examples of broad market index funds include:
- Dow Jones Industrial Average (DIJA)
- Navi Total Market Index Fund
- Motilal Oswal NIFTY 500 Fund
- FT Wilshire 5000 Index (FTW5000)
- Vanguard Total Stock Market Index Fund (VTI)
Market cap index funds
Market cap index funds are indices weighted by a company's market capitalization range (aka market cap), which measures the total value if a company's shares. Indices can be separated based on those values, such as large-cap funds, mid-cap funds, and small-cap funds.
Large-cap values hold companies with market caps of more than $10 billion, small-cap hold companies with market caps of less than $2 million, and mid-cap funds hold companies between $10 billion and $2 billion.
Some examples of market cap index funds include:
- Vanguard Mid-Cap ETF (VO)
- Fidelity 500 Index Fund (FXAIX)
- NIFTY Midcap 150
- SENSEX
- iShares Russell 2000 ETF (IWM)
Equal weight index funds
Funds in equal weight index funds all hold the same weight. This method attempts to prevent of certain companies being overvalued and taking up a majority of the fund's portfolio. Instead, funds in equal weight index funds all hold about the same percentage.
Some examples of equal weight index fund include:
- NIFTY 50
- Invesco S&P 500 Equal Weight ETF (RSP)
- Direxion Nasdaq-100 Equal Weighted Index (QQQE)
Fixed-income and debt index funds
Although most index funds follow stocks, you can also invest in fixed income funds or debt funds. Fixed-come investing is generally low-risk and focuses on investments like bonds, CDs, and money-market funds. It's often best for retirement savings.
Debt index funds operate similarly as fixed-income funds, but also aren't risk free. Debt index funds are susceptible to fluctuating interest rates, as well as credit risks.
Some examples of fixed-income and debt index funds are:
- ICIC Prudential PSU Bond Plus SDL 40:60 Index Fund
- iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)
- Vanguard Long-Term Bond ETF (BLV)
International index funds
A great way to diversify your investment portfolio is with foreign stocks from Europe, Japan, China, France, and more. International index funds are a cost-effective way to invest in assets overseas. But international index funds pose their own risks that domestic funds don't, such as liquidity issues and currency-related problems.
Some examples of international index funds are:
- Vanguard Developed Markets Index Fund Admiral Shares (VTMGX)
- Vanguard Total International Stock Index Fund Admiral Shares (VTIAX)
- Schwab International Index Fund (SWISX)
- Fidelity International Index Fund (FSPSX)
Sector-based index funds
Stocks and other assets from specific sector or industry of the market, such as the financial sector, technology sector, consumption sector, or healthcare sector.
Some examples of sector-based index funds include:
- Motilal Oswal NIFTY Bank Index Fund
- Vanguard Communication Services Index Fund (VOX)
- The Consumer Discretionary Select Sector SPDR Fund (XLY)
- Fidelity MSCI Financials Index ETF (FNCL)
Socially responsible index funds
Socially responsible index funds that track stocks that focus on environmental, social, and governance (ESG) services. Companies involved in industries like tobacco, alcohol, and firearms are excluded from these funds.
Some examples of socially responsible index funds are:
- Vanguard Total Bond Market ETF (BND)
- Schwab US Broad Market ETF (SCHB)
- iShares Global Clean Energy ETF (ICLN)
- SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX)
Index funds — Frequently asked questions (FAQs)
What is an index fund and how does it work?
An index fund are a type of mutual fund or ETF that reflects certain sections or assets of a specific market index for long-term gains. Popular index funds include the S&P 500 or the DJIA. These funds are cheaper and often better performing then actively managed funds, and is more diverse then picking individual stocks.
Are index funds a good investment?
Index funds are a good investment for passive investors looking for low-risk. long-term investment options that can further diversify investment portfolios. Index funds are also often generally low-cost, but can be up to a couple thousand.
Is S&P 500 an index fund?
The S&P 500 is one of the most popular index funds and is made up of 500 of the top US publically traded companies. You can't directly invest in the S&P 500, but you can invest in one of the funds tracking its performance.
Who should invest in index funds?
Index funds are popular because they are a low-risk, low-maintenance, low-cost way to see steady returns over time. But no investment is one-size-fits-all. To see if they suit you, ask yourself:
- Am I looking to invest in the future? Index funds are best suited for investors with a long-term horizon: While the market historically rises over time, you do need time to weather the bumps.
- Am I the buy-and-hold type? Index funds are ideal for those who aren't interested in picking stocks.
- Am I comfortable with slow gains? Index funds typically perform better than actively managed funds over time, but gains are usually moderate. Actively managed funds can sometimes see higher returns in the short term.
Any investment has some risk attached to it, of course. But index funds rank fairly low on the risk spectrum — and are certainly more cost-effective than trying to buy stocks on your own. You may want to consider incorporating index funds into your financial plan.
"Investors simply can't afford to make oversized bets on individual securities," says Johnson. "Investing in a broadly diversified basket of securities is a more prudent strategy."