What is an Index Fund?
Index fund investing got its start in 1976, but in less than 50 years, these funds have grown to represent just over half of all fund investments. It’s clear that both financial experts and individual investors see the virtues of investing in index funds.
What is an index fund, and should you invest in them?
Part of the reason for the rapid growth in index funds is the many benefits they provide.
Examples include:
This is yet another benefit to investing in index funds and one that requires its own discussion.
Because index funds are based on the composition of the underlying index, securities are only traded when there are changes within the index. Since that is a relatively rare event, index funds trade stocks only infrequently. This means they generate little in the way of taxable capital gains.
Instead, the individual share price of an index fund rises over time. No tax liability is generated until you sell your position in the fund. That creates a type of tax deferral normally available only in tax-sheltered accounts, like retirement accounts. The advantage is even greater if you hold your shares for more than one year since any gains will be taxed at lower long-term capital gains rates.
For that reason, index funds can be an excellent choice in a taxable brokerage account, as well as a retirement account.
An index is a popular measure of either the general investment market or specific slices of it. Respected industry institutions, like Dow Jones & Company, NASDAQ Inc., and various large fund families, create indexes that are utilized throughout the industry.
A popular example is the S&P 500 Index, which was created and is managed by S&P Dow Jones Indices. Launched in 1882, the index tracks the performance of the 500 (or so) largest publicly traded corporations in the United States (by market capitalization). As such, it represents approximately 80% of the value of publicly traded stocks on all exchanges in the US. The index is highly valued because it provides the single largest representation of the overall US stock market.
While the S&P 500 Index is considered a more general index, there are many more that are very specific. For example, there are market indexes attached to the performance of specific industries, such as automobiles, airlines, energy, primary metals, consumer durables, consumer nondurables, and healthcare, just to name a few. There are others that are related to geography. For example, there indexes the track the stock markets in Japan, the European Union, the UK, Latin America, and other countries and regions.
Investment managers create portfolios designed to track the underlying indexes. This eliminates the need to research individual companies and buy and sell individual securities in an attempt to outperform the market. Instead, the fund manager maintains the portfolio to match the index, so the fund and index’s performance are identical.
For this reason, index funds are commonly referred to as passive funds. This gets to the fact that they require no active management (buying and selling of securities) by either the fund manager or by individual investors.
Both individual and institutional investors can purchase shares in index funds for their portfolios. When index funds are exchange-traded funds (ETFs) — as most index funds are — they trade like individual stocks. They can be bought and sold through investment brokers, usually commission-free.
If you’ve heard of a market or industry sector, it’s almost certain there’s an index fund tied to it.
Examples include:
That’s just a small sampling of the types of index funds that are available.
Some of the most popular index funds include:
The above funds are so popular that they are frequently included in professionally managed portfolios, as well as robo-advisor portfolios.
One of the major advantages of index funds is their low cost. Unlike actively managed funds, index funds do not charge load fees. This is important because load fees can be as high as 8.5% but are more typically in the 1% to 3% range. However, they are not a factor when it comes to index funds.
As noted earlier, index funds are commonly available through investment brokers commission-free.
However, there is one cost associated with index funds, and that is expense ratios. Expense ratios are annual fees charged within an index fund to cover various expenses, like marketing and administrative costs. They can be as high as 1% of the value of your fund position each year, but index funds are commonly available with expense ratios under 0.10%.
There are various ways you can invest in index funds. Perhaps the most popular way is through investment brokers like Ally Invest, SoFi Invest, and E*TRADE. You can choose from hundreds of index funds with each broker, and all are available commission-free.
If you prefer, you can also invest directly with the sponsoring fund family. Popular fund families include Vanguard, Fidelity, and iShares. Similar to investment brokers, you can purchase positions in index funds commission-free.
Still, another way to invest in index funds is through robo-advisors. These are online, automated investment services that provide complete portfolio management at a very low fee. Popular robo-advisors include Betterment, Wealthfront, and SoFi Invest.
If you prefer to choose your own index funds, and even mix in a few individual stocks, you should investigate M1 Finance. There, you can select up to 100 individual stocks and exchange-traded funds, which M1 Finance will then manage free of charge. You can even create multiple portfolios with the service.
Index funds are often referred to as passive funds because they are not actively managed. Instead, the fund’s composition and performance are tied to a specific underlying index, like the S&P 500, the NASDAQ 100, or a sector stock index. Index funds will neither outperform nor underperform the index.
Since they are usually ETFs, index funds can be purchased in shares or fractional shares in much the same way as you will buy and sell individual stocks. They can either be purchased through the sponsoring fund families or through major brokerage firms.
Yes, because index funds provide a ready-made portfolio of stocks or other investments. As a beginner, there will be no need to research and choose individual securities or manage them going forward. The fund will handle all that, and you will remain fully diversified in the process. No specific knowledge of investing is required to invest in index funds, and you can begin investing with as little as $1.
You can both make money in index funds and lose it. That will all depend on the performance of the underlying index. When it rises, you’ll make money. But when it falls, you could lose money. However, considering that the stock market has traditionally risen over the long term, your investment is highly likely to grow if you hold onto it for many years.
No, the S&P 500 is an index. It represents the approximately 500 largest publicly traded companies on US stock exchanges. However, index funds are commonly based on the S&P 500 Index, making it easy for investors to invest in a diversified portfolio of the country’s largest companies.
Index funds are suitable for investors at all levels, from beginners to advanced. A strong argument can be used to make index funds the foundation of your portfolio. That’s because index funds provide exposure to either entire markets or individual market sectors. All you need to do is choose which you believe will perform the best, then invest in that market through an index fund.
It is commonly recommended that beginners and intermediate investors hold the majority of their equity positions in index funds. This provides the base equity position for their portfolio, and they can also begin gradually investing in individual stocks.
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