The Risks and Benefits of Index Funds

Definition, Benefits, and Risks of Index Funds

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Most investors know that index funds can be smart choices for building a diversified investment portfolio, but you may not know all the benefits of index funds and their advantages over actively managed funds. Learn more about passively managed investing, and find out whether 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.
  • The benefits of index funds include passive management, low expenses, tax advantages, and broad diversification.
  • Risks include low flexibility, tracking errors, and underperformance.

What Are Index Funds?

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

An index is a sampling of stocks or bonds that represent a certain segment of the overall financial markets.

The S&P 500 is an index representing roughly 500 of the largest U.S.-based companies, such as Apple, (AAPL), Amazon (AMZN), Walmart (WMT), Microsoft (MSFT), and Exxon Mobil (XOM).

What Are the Benefits of Index Funds?

There are four major benefits of index funds: passive management, low expenses, tax efficiency, and broad diversification.

Passive Management

Mutual funds can be either actively or passively managed. The manager of an actively managed stock mutual fund buys and sells stocks on an ongoing basis with the goal of "beating the market." This is measured by a certain benchmark, such as the S&P 500.

There's a risk that the active manager will make poor decisions and underperform the benchmark. The majority of actively managed funds lose to their respective indexes, especially over long periods of time, such as three years or more. In contrast, the manager of an index fund that's passively managed only seeks to buy and hold securities that represent the given index for purposes of matching the performance of the index. They're not concerned with beating it.

Low Expenses

The low costs of index funds are a function of their passive management. The costs of managing the fund are much lower than those of actively managed funds when managers don't spend their time and money researching stocks and/or bonds to buy and sell for the portfolio.

These cost savings are then passed along to the investor. Look for the index funds with the lowest expense ratios for this reason. Lower expenses mean that more money is working for you. This 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

Index funds often have very low turnover because they're passively managed. There are few trades placed by managers during a given year. Managers generate fewer capital gains distributions that are passed along to shareholders when they're placing fewer trades.

Broad Diversification

An investor can capture the returns of a large segment of the market in one index fund. These funds often invest in hundreds or even thousands of holdings. Actively managed funds sometimes invest in fewer than 50 holdings.

Funds with higher amounts of holdings have lower relative market risk than those with fewer holdings. Index funds often offer exposure to more securities than their actively managed counterparts.

What Are the Risks of Investing in Index Funds?

Index funds have low flexibility. The fund manager can't buy and sell securities at their discretion to react to adverse market conditions, because these funds are passively managed.

The return to the investor will be different from that of the benchmark if an index fund doesn't accurately track its benchmark index.

An index fund may underperform its benchmark index because of fees and expenses. The index with the lowest expense ratios can more accurately track the index than similar ones with higher expense ratios.

The Bottom Line

Investors should be aware of the risks and benefits of index funds before investing. These funds can be smart choices for many investors, but they're not right for everyone. 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.

Article Sources

  1. U.S. Securities and Exchange Commission. "Investor Bulletin: Index Funds."

  2. Wharton Executive Education. "Active vs Passive Investing: Which Approach Offers Better Returns?"

  3. U.S. Securities and Exchange Commission. "Index Funds and Turnover Rates."