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What Are Index Funds?

Index funds are passive investments that often provide predictable long-term returns. Find out how they work in this article.

Index funds are a great way to generate passive returns over a long period. They’re especially effective for both new and experienced investors who want to invest for the future at a low cost.

So, how do index funds work? And how do they differ from active investment strategies? This article will explain all of that and more. It’ll also outline their benefits and potential pitfalls, as well as cover some important factors to consider if you’re thinking about adding passive investments to your portfolio.

Understanding Index Funds

Index funds allow you to invest in a basket of different types of investments, including stocks, bonds, or other commodities. Their function is to track the performance of broad market indexes, such as the S&P (Standard and Poor’s) 500 or the Russell 3000, to provide reliable returns.

As opposed to buying a stock in one company or type of asset, index funds enable you to spread around and diversify your investments. When you invest in one, you buy a small percentage of shares of each security within the index. Then, the returns you see are based on the average performance of each investment in the fund.

Below are some well-known market indexes:

  • S&P 500. One of the most popular indexes, it includes 500 of the most successful companies.
  • Dow Jones Industrial Average. This includes 30 large companies on the stock market, weighted by their market capitalization (cap).
  • Nasdaq Composite. This comprises nearly every stock on the Nasdaq stock exchange and is one of the most popular broad market indexes.
  • Russell 2000. This contains 2,000 small-cap stocks in the Russell 3000 index and is managed by FTSE Russell.
  • Wilshire 5000. This consists of all the actively traded stocks in the U.S.
  • MSCI EAFE. This includes mid- and large-cap stocks from countries other than the U.S. and Canada. Per MSCI’s website, this includes Europe, Australasia, and the Far East.

Investing in an index fund, like the popular S&P 500, gives you indirect ownership of each company in the index proportional to the amount of money you’ve put in. The attraction of investing in funds like these is that you avoid putting all your eggs in one basket. You get the benefit of returns from successful companies and, even if a handful of them aren’t doing well, you’re still likely to be in the green.

Other funds may only buy a small group of companies or securities. In these cases, managers may use a variety of criteria to select companies that will keep the fund on track to match a market index. Commonly, index funds are market cap weighted. In other instances, they may be equal-weighted, which means the fund invests an equal amount of money into each stock.

Index Fund Expense Ratio

The expense ratio is the amount you pay annually for investing in an index fund. It’s a percentage of your investment that helps keep the fund afloat, paying for operating expenses such as management fees, administration, distribution, and more.

For instance, imagine you’ve invested $5,000 into a fund with a 0.2% expense ratio. In this case, you’d pay $10 each year. This amount automatically gets folded into your returns from investing in the fund, lowering your gains to keep it operational.

Though it seems like a small price to pay, fees can add up over time. So, it’s good to look for funds with lower expense ratios. These help you retain a greater chunk of your passive investment returns.

In general, however, index funds tend to have lower expense ratios than actively managed ones. According to a report by the Investment Company Institute (ICI), the average expense ratio for active mutual funds was 0.66% in 2022 whereas the average in the same year for the former was 0.05%.

Benefits

Index funds are popular because of their simplicity, consistency, and low barrier of entry. They don’t require full-time fund managers, often have low fees, and prove to be steady and reliable investments. Anyone can invest in one and watch as it flows with the market.

Here are some more benefits of investing in one:

Low Fees

Passively managed funds are largely much simpler to manage and assemble than actively managed ones. Because managers put together the fund to replicate the performance of a specific market index, they don’t need to spend extra time actively researching, picking, and selling stocks. This also means that these funds don’t need dozens of employees to work on them, only a few to perform regular maintenance and rebalancing.

All of this translates into lower annual fees (expense ratios) for investors. Thus, gains can be higher without high costs chewing away at returns.

Simple

A major benefit of passively managed funds is their simplicity. As an investor, you can buy into a portfolio that gets automatically balanced and managed over time. This saves you the time of trying to buy and sell individual stocks or beat the market, which can prove to be challenging for even the most experienced financial experts.

Consistent

Since they track a specific market index, index funds tend to be very consistent. They often follow general market trends. So, while there may be occasions where they appear on the downswing, it’s highly likely they’ll bounce back in a reasonable amount of time. 

As an illustration, the unit price of the Fidelity 500 Index Fund (FXAIX), which tracks the S&P 500, has grown 224.42% from 2011 to 2023 from $47.50 to $149.63. While it’s experienced significant dips, namely in 2020 and 2022, it’s followed the overall upward trajectory of the market.

Passive funds are especially helpful for people who invest with a long-term, buy-and-hold strategy, often for retirement. They can hold on to their stake in the fund, likely making more profit than they would by picking individual stocks on their own.

Diversification

Index funds are an easy and accessible way to diversify and mitigate risks. Almost anyone can sign up for a brokerage account or an Individual Retirement Account (IRA) and add one to their portfolio. Upon doing so, you’ll have a combination of stocks, bonds, or other assets. If you invest in a fund with a broad number of companies, such as the Wilshire 5000, the success of the larger number of companies that do well will buoy your returns against the slumping ones at any given time.

Are There Any Disadvantages?

Though index funds have concrete benefits, they still carry risks. The most prominent one is that they’re still vulnerable to the same types of risks as any other investment in the market. And they’ll go down as the indexes they mirror go down.

A further downside is that you can’t select your stocks. Ultimately, you’re at the mercy of whatever securities are in the underlying index the fund tracks, or what the managers decide to select.

Another common risk factor, per Investor.gov, is that some may not keep up with the indexes they track. A normal reason for this could be tracking error. This is where certain factors such as management fees or the fund only using a sample of securities cause a fund not to match a market benchmark. If the fund fails to keep up, returns tend to suffer.

Actively Managed vs. Index Funds

While index funds try to stay as attached to the hip as possible with specific market indexes, actively managed ones aim to beat the market. And they’re run by full-time managers whose bread and butter is strategically picking stocks. These people perform high-level research and analysis to determine which investments carry the best returns.

But with all the expertise behind actively managed funds, the passively managed ones often win out. In a 2022 article, The New York Times observed that “most actively managed mutual funds do worse than their benchmark,” as per studies by the S&P Dow Jones Indices. This is mainly because of the difficulty of fighting for consistency, let alone beating the market. Managers must devise new ways to get ahead, while index funds merely ride the wave.

Active funds also incur higher expenses associated with employing full-time managers, as well as increased trading costs. These can lead to a higher expense ratio than index funds usually have, leading to decreased returns.

Well-Known Providers

Several companies out there allow you to invest in index funds. Many of them have been around for a long time and offer established funds for investors. In no order, here are some of the players in the industry:

  • Vanguard is one of the largest providers. It offers several, including the widely known Vanguard 500 Index Fund Investor Shares (VFINX), that follows the S&P 500.
  • BlackRock offers a variety of options for passive investing. Its iShares product allows customers access to many market indexes, including the S&P 500, MSCI EAFE, and more.
  • Charles Schwab offers many ETFs and index funds, including the Schwab Total Market Index Fund (SWTSX) and Schwab U.S. Broad Market ETF (SCHB).
  • Fidelity has many options, including the FXAIX, sustainability funds, and others.
  • Invesco offers several passively managed products like its S&P 500 fund, SPIAX.

Frequently Asked Questions

Are index funds good investments?

The answer to this question depends on your needs and situation. Index funds have earned a strong reputation for being predictable investments that can produce positive returns, especially for the long term. They probably aren’t the best for people who want to get ahead of the market. But they can be good for people who want to plan for retirement or other distant goals.

Talking to a financial advisor is always a good idea if you’re unsure. They can help you develop an investment strategy or manage your existing portfolio. Completing this quiz will match you with up to three vetted professionals in your area.

Are index funds good for beginners?

Index funds are good for both beginners and those with years of investing under their belt. They’re an easy way to diversify your portfolio, generally have low fees, and can provide solid, reliable returns over a long period.

How do you get money from index funds?

As an investor in the fund, you can sell your shares at your discretion. Index funds may also pay out dividends or interest as other forms of income.

What is an S&P 500 index fund?

These are funds that attempt to mirror the S&P 500 market. Investing in one may give you a sample size of stock in the companies in the index or an indirect stake in every company.

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