The Risks and Benefits of Index Funds

Definition, Benefits and Risks of Index Funds

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Most investors have heard of index funds and that they can be smart choices for building a diversified investment portfolio. But not everyone knows the benefits of index funds and their advantages over actively managed funds. Learn more about passively-managed investing and see if index funds are right for you.

Key Takeaways

  • Index funds are mutual funds or exchange-traded funds (ETFs) that passively track the performance of a benchmark index.
  • Benefits of index funds include passive management, low expenses, tax advantages, and broad diversification.
  • Risks include low flexibility, tracking errors, and under-performance.

What Are Index Funds?

Index funds are mutual funds or exchange-traded funds (ETFs) that passively track the performance of a benchmark index. Examples of indexes include the S&P 500, the Russell 3000, and the Russell 2000. Because of their passive nature, index funds generally have lower expenses and than actively managed funds.

An index, with regard to investing, is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the S&P 500 is an index representing roughly 500 of the largest US companies, such as Apple, (AAPL), Amazon (AMZN), Wal-Mart (WMT), Microsoft (MSFT) and Exxon Mobil (XOM).

What Are the Benefits of Index Funds?

There are three primary benefits of index funds that investors should know before investing. These benefits include passive management, low expenses, tax efficiency, and broad diversification:

  • Passive Management: Mutual funds can either be actively-managed or passively-managed.The manager of an actively-managed stock mutual fund, for example, is actively buying and selling stocks with the goal of "beating the market," which is measured by a particular benchmark, such as the S&P 500. There is risk, however, that the active manager will make poor decisions and under-perform the S&P 500 (the majority of actively managed funds lose to their respective index, especially over long periods of time, such as three years or more). In contrast, the manager of an index fund, which is passively-managed, is seeking only to buy and hold securities that represent the given index for purposes of matching the performance of the index, not to beat it. 
  • Low Expenses: The low costs of index funds are a function of their passive management. When managers are not spending their time and money researching stocks and/or bonds to buy and sell for the portfolio, the costs in managing the fund are much lower than that of actively-managed funds. These costs savings are then passed along to the investor. For this reason, look for the index funds with the lowest expense ratios. Lower expenses mean that more money is working for the investor, which provides potential for outperforming actively-managed funds. Keeping costs low are a key advantage of index funds compared to actively-managed funds. 
  • Tax Advantages of Index Funds: Since index funds are passively-managed, they typically have very low turnover, which means there are few trades placed by managers during a given year. If fund managers are placing fewer trades, they generate fewer capital gains distributions that are passed along to shareholders.
  • Broad Diversification: An investor can capture the returns of a large segment of the market in one index fund. Index funds often invest in hundreds or even thousands of holdings; whereas actively-managed funds sometimes invest in less than 50 holdings. Generally, funds with higher amounts of holdings have lower relative market risk than those with fewer holdings; and index funds typically offer exposure to more securities than their actively-managed counterparts.

What Are the Risks of Investing in Index Funds?

There are a few primary risks of investing in index funds:

  • Low Flexibility: Since index funds are passively managed, the fund manager cannot buy and sell securities at their discretion to react to adverse market conditions.
  • Tracking Error: If an index fund does not accurately track its benchmark index, the return to the investor will be different than that of the benchmark.
  • Under-performance: Because of fees and expenses, an index fund may under-perform its benchmark index. Typically, the index with the lowest expense ratios can more accurately track the index than similar ones with higher expense ratios.

Bottom Line

There are risks and benefits of index funds that investors should be aware of prior to investing. While index funds can be smart choices for most investors, they may not be right for everyone. Some of the most reputable mutual fund companies with a wide variety of low-cost index funds include Vanguard and Fidelity. Investors can also buy index funds through an online discount broker, such as Charles Schwab.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.