What Is An Index Fund?

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Index funds are mutual funds that come with a portfolio designed to track or match a financial index. Index mutual funds provide:

  • Lower risk (due to diversification)

  • Low costs (many charges less than 0.05% compared to 1% charged by actively managed mutual funds)

  • Broader market exposure through diversification

It doesn’t matter what state the market is in; the funds will follow the benchmark set by the index.

An index fund is usually considered to be the ideal portfolio holdings for retirement accounts like the 401k or IRAs. Even billionaires like Warren Buffett have recommended index funds as the best way to save for retirement. Instead of buying individual stocks, you can buy every company in the S&P 500 through a low cost of the index fund.

How Do Index Funds Work?

What is an Index Fund

Index funds are part of the passive fund management design. They mirror an index. The fund manager will build the portfolio around the holdings that are similar to securities from any index instead of choosing to invest based on market timings and stock pricing. The basic idea behind an index fund is that by matching the index profile, you will match its performance too.

Index funds have been created for every financial market. The most popular index funds in the US include:

  • S&P 500 (500 of the largest companies in the US)

  • Russell 2000 (includes small-cap companies)

  • Wilshire 5000 Total Market Index (the largest equities index in the US)

  • MSCI EAFE (includes foreign stocks from the Far East, Australia, and Europe)

  • Barclays Capital US Aggregate Bond Index (includes the complete bond market)

  • Nasdaq Composite (includes 3000 based on the Nasdaq exchange)

  • Barclays Capital US Aggregate Bond Index (includes 30 companies)

  • Total Stock Market Funds

  • Total International Stock Market Funds

  • Emerging Market Index Funds Funds

  • Total Bond Market Index Funds

If you choose the DJIA, for example, you will be investing in all the 30 publically-owned, large-cap companies that are part of the index. Index fund portfolios only change significantly when the benchmark index experiences change. For example, the fund follows a weighted index.

The portfolio managers may frequently rebalance the securities percentages to make sure that they reflect the weight on the benchmark index.

Things to Note

  • An Actively managed fund has higher fees (usually around 1%) than index funds.

  • Index funds are great for anyone who wants to invest passively.  

  • Index funds are portfolios of bonds or stocks that mirror the performance and composition of the financial market index.

  • Index funds are based on the return and risk of the market since the market can outperform individual investments in the long term.

Actively Managed Funds vs. Index Funds

Family Playing

While investing in index funds is known as passive investing, active investment is realized through actively managed funds. They are based on market timing and security picking.

Lower Costs

The advantage of index funds is that they have a lower expense ratio. Actively managed funds require an expense ratio that is based on accounting fees, taxes, transaction fees, and salaries for managers and advisors.

Index fund managers can work without research analysts and advisors since they only need to match the fund to the index. They don’t need a whole team to select stock and process it. Index fund managers also trade stocks and holdings less frequently, which results in lower costs for commissions and transaction fees. On the other hand, actively managed funds require more transactions and staff, which can increase the cost.

The extra cost can reflect on the expense ratio by the fund that is passed onto the investor. This is why you will be able to find index fund management costs around 0.2% or less. With many offering 0.05%.

Actively managed funds have a typical ratio of 1-2.5%. The expense ratio can impact the performance of the fund. This may not seem like a lot but can affect your returns by thousands of dollars over a decade.

Pros of Index Funds

  • Ultimate diversification

  • Low expense ratio

  • A stronger long term return

  • Ideal for buy-and-hold passive investors

Cons of Index Funds

  • Market crash/swing vulnerability

  • Low flexibility

  • No human elements

  • Limited gains

Do Index Funds Have Better Returns?

The lower expense does lead to better performance. Experts have found that passive funds outperform most actively managed funds. Most mutual funds have failed to beat broad indexes. However, passively managed funds don’t aim to beat the market. The strategy is focused on the return and risk of the market. Hence, the market will always win.

Passive fund management tends to lead to better performance in the long term. In shorter timelines, actively managed funds can do better. In the long term, only great actively managed funds yield great responses.

Here is the biggest stat in favor of Index Funds. Only 13% of around 8,000 mutual funds are able to achieve outperforming the market index!  

History of Index Funds

Looking into Index Funds

Index funds have been part of the financial industry since the 1970s. Passive investing grew in popularity due to the appeal of low costs. In the 2010s, the bull market’s long-run made index funding soar. In 2018, $458 billion was poured into index funds by investors from all types of asset classes. In the same timeframe, $301 billion in outflow was experienced by the actively managed funds.

The fund that made index funds popular was designed by John Bogle, a Vanguard Chairman, in 1976. It still remains one of the best in terms of low cost and long term performances. The Vanguard 500 Index Fund still stands with the S&P 500 in performance and composition.

Best Index Funds

Vanguard Total Stock Mkt Idx Inv (VTSMX)

  • Expense Ratio: 0.140%
  • Minimum Investement: $3,000
  • Average Returns (Here)

Vanguard 500 Index Investor (VFINX)

  • Expense Ratio: 0.140%
  • Minimum Investement: $3,000
  • Average Returns (Here)

Fidelity Spartan 500 Index Investors Shares (FUSEX)

  • Expense Ratio: 0.150%
  • Minimum Investement: $3,000
  • Average Returns (Here)

Schwab S&P 500 Index Fund (SWPPX)

  • Expense Ratio: 0.03%
  • Minimum Investment: $1.00
  • Average Returns (Here)

Conclusion

The index fund is a great investment plan for the long term. Since you just need to match the market index with your portfolio, you don’t need to employ a lot of financial tact or knowledge. This can be a great way for beginners to get into the investment scene. However, you should still do ample research before choosing an investment plan.

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