Index funds are a type of mutual fund or exchange-traded fund (ETF) that are made up of stocks or bonds that attempt to earn the same return as a particular index. Weigh the pros and cons to decide whether they're the right choice for you. You should know how index funds are compared to actively managed funds before you choose one or more for your portfolio.
What Is an Index Fund?
Thousands of indexes track the movements of sectors and markets on a daily basis. They're used to gauge that market’s health and performance. The Dow Jones Industrial Average is a broad market index made up of 30 blue-chip stocks. 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 a way to weigh performance.
You can't invest directly in an index, but you can invest in a fund, through either an index mutual fund or an ETF. Most index funds copy the index by holding all the index’s securities. Sometimes a fund approximates the index with a sample of the securities or with additional derivatives, such as options and futures.
Index funds represent less than 40% of assets held in mutual funds.
Index funds are passively managed. They tend to hold on to what's in the index (which rarely changes) to maximize returns and minimize costs. Most mutual funds and a few ETFs are actively managed. Fund managers can 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 gaining from millennial generation spending habits
- Direxion Work From Home ETF (WFH): U.S. companies gaining from people working at home
Pros and Cons of Index Funds
Lack of flexibility
Pros of Index Funds
You should get the same return as the index, minus fund-management costs, if you invest here. Index funds have better returns than actively managed funds in most cases.
An index fund’s portfolio rarely changes. This stability results in lower trading costs and taxes. The fund’s operating costs are reduced, because there’s no need to hire portfolio managers or stock researchers, or to pay commissions that arise from constant trading. Active fund costs are about 1.3%, or $1.30 for every $100 in the fund.
Many index funds simply hold what's in the index, so you can always see the fund's holdings. Thiat lets you better judge an index fund’s risk based on those holdings. An index fund that's tracking the volatile oil and gas sector may be much more of a risk than a bond index fund.
You can buy slices of hundreds or thousands of companies at once rather than single stocks as you're trying to create your own portfolio. This diversification cuts back on risk. If one stock or bond is down for the day or a year, another is most likely up.
Cons of Index Funds
The fund typically holds the same securities, no matter the market's direction, because its purpose is to track the index. The fund manager can’t sell stocks that are underperforming, especially during a broad market decline.
This lack of flexibility means that index funds aren't likely to post a return higher than the benchmark. You're guaranteed the index's return when the market (or sector) rallies, but you're also guaranteed the index's loss when the market falls.
The difference between an index fund’s return and the performance of its parent index mirrors the costs to run a portfolio. This is called a “tracking error.” Always go for the one with a smaller tracking error when you're comparing index funds that track the same index.
Indexes aren't objective. They're created by companies that determine an index’s makeup. The decision-making process isn’t strongly regulated. It's not always transparent and can be influenced by overall management tactics. Sometimes the index funds and the index have the same managers, which can create a conflict.
How Should You Choose an Index Fund?
You should weigh a few important factors before buying an index fund. First, how much risk are you willing to take for the return? What are the risks associated with the fund you're eying? Does its strategy fit into your investment goals?
How much will you pay for buying, owning, and selling the fund? Compare transaction costs of funds that cover the same sector. And, last but not least, how soon will you need the money?
Are Index Funds Good Investments for You?
Index funds, ETFs, and mutual funds have consistently outperformed actively managed funds. They can be very good investments, but they’re not all equal, so always do your research. You might be able to find your own answers, or you may need the help of an advisor.
NOTE: The Balance does not provide tax, investment, or financial services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be right for all investors. Past performance isn't indicative of future results. Investing involves risk, including the possible loss of principal.