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Updated on Thursday, April 23, 2020
Low-cost, low-risk, simple and effective — index funds check most of the boxes people want in their investment tools. They’re also widely hailed by experts as an average investor’s best bet to reach their long-term investment goals. But what exactly is an index fund, and more importantly, is it right for your portfolio?
- What is an index?
- What is an index fund?
- What to know about index fund investing
- Pros and cons of index funds
- How is an index fund different from a mutual fund?
- Top index funds
What is an index?
At the most basic level, an index is a measurement of how well a related group of stocks or other assets are performing — a thermometer of sorts. Before we dive too far into index funds, it’s first important to understand what an index is.
Indices may include just a handful of stocks or other assets, or they may include hundreds or thousands of them. The performance of the companies or commodities within each index are factored together to gauge the performance of the overall group.
There are thousands of market indices. Some of the largest stock indices include:
- Dow Jones Industrial Average (DJIA): This is one of the oldest indices, established back in 1896. The DJIA index includes 30 large-cap stocks, such as Microsoft, Disney, Walmart and more.
- S&P 500: This index includes 500 mid-cap and large-cap companies, such as Apple, Microsoft, Boeing, Nordstrom, Starbucks and other industry leaders.
- Russell 2000: This index is made up of 2,000 small-cap stocks.
Indices aren’t just for stocks, however. They exist for an array of different asset classes and segments of the economy. They serve as indicators of how a related group of assets — like large- or small-cap stocks, or a group of companies in the same industry — are performing. Some of the largest non-stock indices include the Chicago Board Options Exchange’s (CBOE) Volatility Index, the Consumer Price Index (CPI) and the Producer Price Index (PPI).
Market indices are established by financial firms and government regulators, but you can’t invest in indices directly. You can, however, invest in index funds.
What is an index fund?
Index funds are made up of stocks and bonds that replicate the makeup of an underlying index. The goal is always to match the performance of the underlying index as closely as possible.
Some index funds invest in all of the stocks or other assets that comprise the underlying index, while others are more selective and only invest in a portion of the assets that make up the index. For instance, the component stocks in an index may be weighted, meaning the performance of the entire index is impacted more heavily by the performance of a chosen subset of companies within the index.
What to know about index fund investing
For investors, investing in index funds means that instead of picking and choosing each individual stock to invest in, they’re investing in a predetermined group of stocks. This delivers that key component often thought to be so essential to successful investing — diversification. Your profits and losses are measured by how the collective group of companies within the fund does rather than just on how one stock performs. In other words, your proverbial eggs aren’t all in one basket.
Index funds are a passive form of investing. Since the investments are predetermined by the indices, not only do you not have to individually choose the stocks, actively follow them and make decisions about when to buy or sell them, but an advisor doesn’t have to either. Therefore, the fees you must pay to an advisor are typically lower.
Another bonus: Since index funds are meant to be held for long periods of time rather than to be bought and sold as the market fluctuates, investors often benefit from some tax advantages, such as avoiding short-term capital gains taxes. Less money spent on fees and taxes means more money to invest and accumulate interest.
Pros and cons of index funds
- Simple to understand: You don’t have to be a financial expert to understand and invest in a mutual fund. They’re quite straightforward, and once you invest in one you can “set it and forget it,” knowing your money is working for you.
- Offer diversification: Index funds pool investors’ money together in order to purchase shares. This allows people to invest in a broader array of companies than most average investors would likely be able to do if they tried to invest in each one within an index separately.
- Low cost: Because index funds require little work on the behalf of a financial manager, the fee for them is typically less than those associated with actively managed mutual funds. There may also be tax benefits since they’re meant to be held long-term instead of being frequently bought and sold.
- Lower risk than other investments: Because you’re investing in a group of companies rather than just one or a few, you take much less of a hit if one tanks. The swings of a group of companies are typically less volatile than those of individual companies.
- Potentially lower returns: The biggest drawback to index funds for some is that they may not provide the huge payoffs compared with some actively managed accounts that try to beat the market. They do, however, traditionally perform well in the long term.
- Not designed for frequent trading: If you’re someone who likes to buy and sell stocks frequently and participate in day trading, index funds may not be your best choice. They can only be purchased and sold once a day, and they’re better used as long-term investments.
How is an index fund different from a mutual fund?
An index fund is actually a type of mutual fund. Mutual funds are financial vehicles that pool investors’ money and invest it in groups of stocks, bonds and other assets within certain segments. For example, some mutual funds may invest in foreign stocks, while others invest in domestic stocks.
Passive management: What sets index funds apart from mutual funds is that they’re invested to match the performance of one of the market indices. While most mutual funds are actively managed by a professional fund manager who decides how to allocate the investments and when to buy and sell them, index funds are a subset of mutual funds that are passively rather than actively managed.
Less work — and lower fees: The work to set up and maintain your investments in an index fund is quite simple and doesn’t require the same amount of research and work that other mutual funds do. Once you invest, there’s no worry about following the markets and trying to gauge when to buy and sell. Index funds are meant for long-term growth, and you can simply “set and forget” them until you need the funds down the road. Therefore, the fees associated with them are typically much lower.
Likely lower returns: Will index funds see the same huge returns that some (rare) individual stock investments do? Probably not, but, in general, they’re less risky than actively managed accounts that try to beat the market. Typically, they perform better, too. According to the December 2019 S&P Indices vs. Active funds scorecard, over a five-year period, the S&P 500 index did better than 80.6% of actively managed stock funds.
Top index funds
Perhaps the most challenging part about index fund investing is picking the one(s) in which you want to invest. As we said, there are literally thousands of index funds from which to choose. A financial advisor can help you narrow down your choices, but in general, you want to look at the following three factors when choosing an index fund:
- Makeup of the index: Which type of companies and commodities is the index following? Do you want to invest in a certain sector or in a more diverse range? Look at your existing portfolio and see how you might be able to add some diversity.
- Minimum investment: This is the amount you need to have upfront to start investing in a particular fund. While the amount varies by fund, the minimum investment typically falls between $500-$3,000.
- Expense ratio: You’re not presented with a bill for the fees associated with your index fund — rather, they’re deducted from your fund in the form of an expense ratio. The ratio is a fixed annual percentage of your assets. So if you have $1,000 invested in a fund with a 0.05% expense ratio, 50 cents per year will be deducted from your fund. You can find many index funds with expense ratios of .05% or less. You may want to think twice about any that exceed .10%.
Here are some of the top index funds you may want to consider:
Vanguard S&P 500 Index fund
The Vanguard S&P 500 Index fund is the oldest index fund for individual investors. It includes 500 of the largest companies in the United States in various industries (those in the S&P 500). The Admiral Shares fund requires a minimum $3,000 investment and has an expense ratio of 0.04%.
Schwab S&P 500 Index Fund
The Schwab S&P 500 Index Fund was founded in 1997. As its name implies, it also follows the S&P 500. There is no minimum deposit required, and the expense ratio is 0.02%.
iShares Barclays Capital U.S. Aggregate Bond Index Fund
The Barclays Capital U.S. Aggregate Bond Index follows bonds, and there are a variety of funds that follow it, including the iShares U.S. Aggregate Bond Index Fund, which is one of the most prominent. Its expense ratio is 0.04%, and the minimum investment is $1,000 with a few exceptions.
Invesco DB Commodity Index Tracking Fund
The Invesco DB Commodity Index Tracking Fund invests in the commodities included in the DBIQ Optimum Yield Diversified Commodity Index Excess Return. The index is made up of 14 heavily traded commodities, including heating oil, gold, silver, corn, wheat and sugar. The expense ratio is 0.89%, and while there is no minimum investment listed, they do warn that there may be substantial risk investing in it as futures contracts are volatile.