Investing in Index Funds for Beginners
Why Buying the Index Makes Sense
You may have heard about index funds from a friend, on TV, or on a podcast. But what are they, exactly? An index fund is a type of mutual fund or exchange-traded fund (ETF). It’s made up of stocks or bonds attempting to earn the same return as a particular index.
But are index funds right for you? Learn the pros and cons, how index funds compare to actively managed funds, and how to choose an index fund for your portfolio.
What Is An Index Fund?
Thousands of indexes track the movements of various sectors, markets, and investment strategies on a daily basis, and are used to determine that market’s health and performance. For example, the Dow Jones Industrial Average is a broad market index made up of 30 blue-chip stocks, while the U.S. Global Jets Index tracks the global airline industry as a sector index. The index can also act as a market's benchmark, or way of measuring performance.
You can't directly invest in an index, as it's purely a mathematical construct. However, you can invest in an index fund, either through an index mutual fund or an ETF. Most index funds copy the index exactly by holding all the index’s securities, but sometimes a fund approximates the index with a sample of the securities, or additional derivatives, such as options and futures.
Index funds represent less than 40% of assets invested in mutual funds.
Index funds are passively managed, which means they typically hold what's in the index (which rarely changes) to maximize returns and minimize costs. Most mutual funds and a few ETFs are actively managed, giving fund managers the ability to trade any security in their market segment as often as they like in an effort to beat the benchmark.
Here are a few examples of index funds and what each one tracks:
- Vanguard 500 Index Fund (VFIAX): 500 of the largest companies in the U.S.
- iShares Russell 2000 ETF (IWM): 2000 U.S. small-cap stocks
- Fidelity Sustainability Bond Index Fund (FNDSX): Bonds that meet environmental, social, and governance criteria
- Global X Millennials Thematic ETF (MILN): U.S. companies benefiting from millennial generation spending habits
- Direxion Work From Home ETF (WFH): U.S. companies benefiting from people working at home
Pros and Cons of Index Funds
Lack of flexibility
Rarely outperforms the index
Pros of Index Funds
- Dependable performance: Investors should get the same return as the index, minus fund-management costs. Historically, index funds have better returns than actively managed funds.
- Lower costs: The composition of an index fund’s portfolio rarely changes, which results in lower trading costs and lower taxes for the investor. As well, the fund’s operating costs are reduced, as there’s no need to hire portfolio managers, stock researchers, and pay commissions from constant trading. On average, active fund costs are about 1.3%, or $1.30 for every $100 in the fund.
- Transparency: Many index funds simply hold what's in the index (which rarely changes) so investors can see the fund's holdings anytime. This transparency lets you better judge an index fund’s risk based on those holdings. For instance, an index fund tracking the volatile oil and gas sector may be much riskier than a bond index fund.
- Simple diversification: Rather than buying individual stocks and attempting to create your own portfolio, you can buy slices of hundreds or thousands of companies at once. The diversification inside that ready-made portfolio minimizes risk—if one stock or bond is down (for the day or a year), another is probably up.
Cons of Index Funds
- Lack of flexibility: Because the fund’s mandate is to track the index, the fund typically holds the same securities, no matter the market's direction. The fund manager can’t sell stocks that are underperforming, especially during a broad market decline.
- Rarely outperforms the index: The lack of flexibility means index funds are unlikely to post a return higher than the benchmark. And while investors are guaranteed the index's return when the market (or sector) rallies, they are also guaranteed the index's loss when the market falls.
- Tracking error: The difference between an index fund’s return and the performance of its parent index is a reflection of the costs to run a portfolio. This is called a “tracking error.” When comparing index funds that track the same index, always go for the one with a smaller tracking error.
- Management differences: Indexes are not objective scientific measurements, but created by companies that determine an index’s makeup. The decision-making process isn’t heavily regulated and not always transparent and can be influenced by overall management approaches. Sometimes the index funds and the index have the same managers, which can create a conflict of interest.
How Should I Choose an Index Fund?
Before buying an index fund, investors need to evaluate a few important factors:
- Risk tolerance: How much risk are you willing to take for the anticipated return, and what are the specific risks associated with the fund? Does this fund's strategy fit your investment goals?
- Fees: How much will you pay for buying, owning, and selling the fund? Comparing funds that cover the same sector is a good way to compare costs.
- Time horizon: How soon will you need the money?
As with any investment vehicle, the investor should read all the information available about the fund, especially the fund's prospectus.
The Bottom Line: Are Index Funds a Good Investment?
Over the past 10 years, index funds, ETFs, and mutual funds have consistently outperformed actively managed funds. In general, index funds can be a very good investment. However, before investing, carefully research possible index funds or ETF buys, as they’re not all alike. Some investors can find their own answers, and others may need the help of a financial advisor.
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.
Vanguard. "Don't Stop Believing in the Power of Indexing." Accessed July 21, 2020.
The Wharton School. "If Index Funds Perform Better, Why Are Actively Managed Funds More Popular?" Accessed July 21, 2020.