How Index Funds Work

Why index funds may be the only investment you need

A simple retirement saving formula.
A simple retirement saving formula. David Franklin/Getty Images

If you are investing for retirement and don't know where to start, consider an index mutual fund or exchange-traded fund (ETF). Index funds invest in a set group of companies, or a market index. The Standard & Poor's 500 Index, for example, is made up for 500 of the country's largest companies. An S&P 500 fund will give you access to shares of those 500 companies.

Other widely used market indices include the Russell 2000, a market index of 2,000 small-company stocks; the Wilshire 5000, which includes all U.S. equity securities that have readily available prices; the Dow Jones Industrial Average, which is a price-weighted average of 30 actively traded blue chip stocks (primarily industrials), the NYSE Composite, an index that comprises all the companies on the New York Stock Exchange, and the NASDAQ Composite, which includes thousands of companies on the NASDAQ stock exchange.

So why would you want an index fund over its alternative, an actively managed fund? Index funds do not rely on managers to pick the stocks. They tend to follow the moves of the larger market. Actively managed funds need brilliant stock-picking managers behind them to beat the market. Most of them don't. In fact, studies have shown that over time, index funds consistently outperform actively managed funds. Here's why an index fund may be right for you.

Index Funds Have Lower Fees

Because there are no stock pickers to pay, index funds tend to cost a lot less than actively managed funds. Actively managed fund fees average about 1.25 to 1.5%. You can get an index fund from Vanguard, Fidelity or T. Rowe Price for an annual fee of less than 0.50%. Another option for investors looking for lower fees is to opt for an exchange traded fund (ETF). ETFs are similar to index mutual funds but also trade like a stock.

Both index mutual funds and ETFs provide you investing options if you are looking for something cheaper than an actively managed fund with higher expenses.

It may not sound like much, but over time those fees do add up. And they can eat away at your return. If you are lucky enough to find a fund that beats the performance of the larger market by 1%, but you pay 1% more for that fund than you would for a market index fund, you wind up not beating the index at all.

Whatever type of fund you choose, you should always look for no-load funds. This means there are no costly sales loads or commissions to pay.

Index Funds Are More Tax-Efficient
One consequence of trying to buy and sell a lot of stocks in an attempt to beat the market: you rack up a lot of taxable transactions. This makes actively managed funds less tax-efficient than index funds, which tend to make fewer transactions and instead stick to a basket of predetermined investments. Again, these fees may seem irrelevant considering the size of some mutual funds, but they do add up. And they can impact your bottom line.

Index Funds Help You Diversify
Because index funds tend to follow broad market indices, you can easily get exposure to a diversified stock portfolio. For example the Russell 3000 Index follows 3000 of the largest companies in the U.S. The Wilshire 5000 is also known as the total market index, because it tracks pretty much every company in the stock market.

Actively managed funds will often have set objectives or criteria that they use to choose their investments. For example, a fund may aim to outperform the S&P 500 by investing in companies that are undervalued. That means the managers have to find those stocks they deem are undervalued, and among those they must pick the stocks they think will do really well.

Aside from the difficulty in picking winners with a strategy like this, the manager may wind up investing in a small group of stocks instead of a large group that minimizes the risk. Attempting to get broad market exposure through actively managed funds can mean owning a lot of funds – which means more fees.

Index Funds Perform Like the Market
Remember the part about how actively managed funds will try and beat the S&P 500? Most actively managed funds will benchmark their own performance to an index. Because if you can't beat the larger market, you want to perform as well as it does. In their attempt to beat the S&P 500, managers may have to try a lot of different stocks, buying and selling throughout the year. Sure, some managers are bound to be stock whizzes some of the time. You may even see them touted in investing magazines.

But it's rarely sustainable over the long-term. This is why "hot" funds are not always hot several years in a row. In fact, if a fund had a great year last year, history has shown that you'd probably do better to stay away this year.

Index funds by design will always perform as well as their index. When the market has a great year, so do index fund investors.

There are some segments of the market where stock picking may make a difference. When picking small-cap or emerging market companies, for example, the manager's instinct or knowledge of the companies he or she covers may offer an edge. But if you want a simplified, low-cost investing strategy, an index fund may be the only investment you need.