Index funds are a type of mutual fund or exchange-traded fund (ETF) that holds stocks or bonds to match a certain index, like the S&P 500 or Dow Jones Industrial Average.
A basket of stocks, bonds, or other types of securities make up an index. These securities are put into groups based on rules, such as where the business is located, how big it is, or what it does.
Index funds are managed in a passive manner. Since index holdings don’t change often, index funds don’t trade securities very often. Active management is used for most mutual funds and a few ETFs. To try to beat the benchmark, active fund managers can buy and sell any security in their market segment as often as they want.
Index funds are a fantastic entry point for new investors
Experts generally consider index funds as a good investment strategy for investors beginners. However, it’s important to know how to choose the right fund and what its pros and cons are.
They are affordable, let you spread your money around, and tend to give you good returns over time. In the past, index funds have done better than other types of funds that top investment firms actively manage.
It is a common sense that index funds are the best core holdings for retirement accounts, and Warren Buffett, a famous investor, has said that index funds are a safe place to put savings for later in life.
He has said that instead of picking individual stocks to invest in, it makes more sense for the average investor to buy an index fund that gives them access to all of the S&P 500 companies at a low cost.
Since the 1970s, index funds have been around. In the 2010s, they went up a lot because of how popular passive investing is, how appealing low fees are, and how long the bull market has been going. Morningstar Research says that investors put more than $400 billion into index funds across all types of assets in 2021. During the same time period, $188 billion left actively managed funds.
The most popular index funds
For almost every financial market, there is an index and an index fund. Most index funds in the United States track the S&P 500. But many people also use a number of other indexes, such as:
Wilshire 5000 Total Market Index
It is the biggest stock market index in the United States.
MSCI EAFE Index
It is made up of foreign stocks from Europe, Australasia, and the Far East.
Bloomberg U.S. Aggregate Bond Index
It tracks the entire bond market.
The Nasdaq Composite Index
It is made up of 3,000 stocks that are traded on the Nasdaq exchange.
The Dow Jones Industrial Average (DJIA)
30 companies with big market caps make up this index.
Why you might want to invest in index funds
If you want to spread out your investments in different ways, an index fund is a simple way to do it. When someone wants to buy stocks but doesn’t know which ones to buy, they can use a broad stock index fund to buy a variety of stocks all at once.
You can also use Index funds to change the amount of risk in your portfolio without having to sell anything. For example, if you own an S&P 500 index fund but don’t think it has enough health care stocks, you can buy a health care ETF to increase your exposure to that sector. On the other hand, if you think there are too many health care stocks in the S&P 500, you can use a bearish health care ETF to short this sector.
Index funds have pros
Reliable performance
If you invest here, you should get the same return as the index, minus the costs of running the fund. Most of the time, index funds have better returns than funds that are actively managed.
Less expensive
An index fund’s portfolio doesn’t change very often. Because of this stability, trading costs and taxes are lower. The fund’s operating costs are lower because it doesn’t have to pay for portfolio managers, stock researchers, or commissions that come from trading a lot. The costs of an active fund are about 1.3%, or $1.30 for every $100 invested.
The fund’s holdings are always transparent
This is because many index funds just hold what’s in the index. So, you can better figure out how risky an index fund is based on what it owns. An index fund that follows the volatile oil and gas sector could be much riskier than an index fund that follows bonds.
Simple diversification
Instead of buying one stock at a time, you can buy pieces of hundreds or thousands of companies at the same time. This reduces the amount of risk. Most of the time, if one stock or bond goes down for the day or year, another one goes up.
Why you might not want to invest in index funds
Some investors want to buy stocks, while others want to beat the market. If your goal is to make more money than the average investor, you can’t use funds that mimic the average performance of the index you’re trying to beat.
There are also other benefits to investing in stocks or bonds directly. If you own stock, you have the right to vote, and you’ll get dividend payments directly from the company instead of the average payment for a whole sector. Individual bonds have a maturity date that tells you when you’ll get your principal back. Bond ETFs, on the other hand, always reinvest maturing bonds into new ones.
Index funds have cons
Not being able to change
Because its goal is to track the index, the fund usually holds the same securities no matter which way the market goes. The fund manager can’t sell stocks that aren’t doing well, especially when the market as a whole is going down.
Can’t outperform
Because index funds don’t have much room for change, it’s unlikely that they’ll get a better return than the benchmark. You will for sure make money on the index when the market (or sector) goes up. But you are also sure to lose money on the index when the market goes down.
Tracking error
The cost of running a portfolio is equal to the difference between an index fund’s return and how well its parent index did. They called it a “tracking error”. When comparing index funds that track the same index, always choose the one with the smallest tracking error.
Management differences
Indexes are not unbiased. Specialized business entities decide what makes up an index. There aren’t many rules about how portfolio managers make decisions. It’s not always clear, and how management works as a whole can affect it. Sometimes, the same people run both the index funds and the index, which can lead to problems.
Bottom line
Index funds follow portfolios that are made up of a lot of stocks. So, investors get to enjoy the good things that come from diversification, such as a higher expected return on the portfolio and less risk overall. Any stock’s price could drop sharply, but if it is just a small part of a bigger index, it wouldn’t be as bad.
Most experts agree that index funds are great investments for people who plan to keep their money for a long time. They are low-cost ways to get a portfolio that follows an index and is well-diversified. Compare different index funds or ETFs to make sure you are following the best index for your goals and at the lowest cost.
