Index funds are a type of mutual fund that maps to a market index. Indices include the S&P 500, which is made up of 500 of the largest companies traded on the New York Stock Exchange and the Nasdaq exchange, the Dow Jones Industrial Average, consisting of 30 “blue-chip” companies, and others. Index funds are considered “passive” investments because they don’t have a money manager who buys and sells companies within the fund. Their objective is to mirror the return of the index they map to. In 2018, according to Morningstar, just 38% of actively managed funds outperformed their passive peers.
Investors might consider index funds if they want to match, but not outperform, the larger market. Index funds, like any investment, have advantages and disadvantages and may not be right for every investor. Read on to see if investing in index funds is a good idea for you.
This guide to index funds will cover:
- What Are Index Funds?
- Types of Index Funds
- Disadvantages of Index Funds
- Benefits of Investing In Index Funds
- Investing In Index Funds: Glossary of Terms
- Should I Invest In Index Funds?
- A Note About ETFs
An index fund is a type of mutual fund that attempts to mirror the return of a market index. An index is a group of stocks, taken as a whole, representing all or part of the greater stock market. The S&P 500 is a popular index and consists of 500 of the largest U.S. companies traded on the NYSE or Nasdaq exchanges. The Russell 2000 is another popular index, consisting of 2,000 smaller-cap companies.
Investors cannot invest in an index, but they can invest in an index fund. The index fund will buy shares of some or all of the stocks in the index, in the same proportion as the index, so the return of the fund will map very closely to the return of the index itself.
The Dow Jones Industrial Average, often referred to as simply “the Dow,” is the index that is often thought of as representative of the market. Investors can buy index funds that include the Dow stocks, such as the SPDR Dow Jones Industrial Average ETF.
The 30 companies that comprise the DJIA are:
|Companies in the Dow Jones Index|
|American Express Co.||AXP|
|Cisco Systems Inc.||CSCO|
|Exxon Mobil Corp.||XOM|
|Goldman Sachs Group Inc.||GS|
|International Business Machines Corp.||IBM|
|Johnson & Johnson||JNJ|
|JPMorgan Chase & Co.||JPM|
|Merck & Co. Inc.||MRK|
|Proctor & Gamble Co.||PG|
|The Walt Disney Company||DIS|
|Travelers Cos. Inc.||TRV|
|United Technologies Corp.||UTX|
|Verizon Communications Inc.||VZ|
|Walgreens Boots Alliance Inc.||WBA|
Are Index Funds Typically Cheap or Expensive?
Index funds may have lower costs than actively managed mutual funds. Actively managed funds have a fund manager who decides which stocks to buy and sell in the fund and needs a research staff to help with those decisions. Index funds don’t require research or management, so their costs may be lower. But every index fund doesn’t necessarily have lower costs than every actively managed fund, so check the actual expenses of funds you are considering.
Are Index Funds a Popular Investment Strategy?
Nearly half of all U.S. invested assets are invested in index funds, according to Quartz. If you have money invested in a 401(k) or other employer retirement plan, you probably already own index funds.
There are various types of index funds, ranging from broad market funds that map to the entire stock market to specific sector funds that may map to a small segment of a particular industry. Here are some different types of index funds:
Broad Market Index Funds
Broad market index funds map to an index that represents a large portion of the market, or even the entire market. The Vanguard Total Stock Market Index fund is an example of a fund that provides exposure to the total U.S. equity market.
Sector Index Funds
Sector index funds track indices in a specific sector of the market, such as transportation or technology. The Vanguard Information Technology Index Fund maps to the MSCI US Investable Market Information Technology index, for example.
International Index Funds
International index funds invest in indices outside the United States. They may mirror the entire non-U.S. market or a certain region. The iShares Core MSCI Pacific ETF, for example, mirrors the MSCI Pacific Investible Market Index.
Bond Index Funds
Bond index funds can combine short-, intermediate- and long-term bonds to provide good diversification for the bond investor. Or, they can focus on a single duration, like the Fidelity Short-Term Bond Index Fund, which maps to the Bloomberg Barclays U.S. 1-5 Year Government/Credit Bond Index.
Growth Index Funds
Growth index funds and value index funds track their respective indices based on whether they’re expected to grow earnings or appreciate in value. An example of this is the Schwab Large-Cap Value ETF, which mirrors the performance of the Dow Jones U.S., Large-Cap Value Total Stock Market Index.
Check Out: What Are Open and Closed End Funds?
Dividend Index Funds
Dividend index funds provide income from the dividends generated by the stocks in which they invest. One fund that tracks the S&P High Yield Dividend Aristocrats Index is the SPDR S&P Dividend ETF.
Also Consider: 7 Best Long-Term Investments
As with all investments, there’s risk associated with index funds. The price of an index fund can — and does — go down as the investments it contains drop in price. You can lose the money that you have invested in an index fund.
An index fund is passively managed, meaning that the funds are chosen based on the investments in the index it tracks, not on an expert’s opinion of how those investments are likely to perform in the future. It will only perform as well as the index it maps to. And it might even underperform that index because of the fees the investor is charged.
Index funds have some advantages over other types of investments, including:
- Lower expenses: Index funds are passive investments, so they don’t require a fund manager and a team of analysts to determine which investments to buy and sell. This passivity reduces their costs.
- Tax efficiency: Because the investments in indices typically change infrequently, index funds don’t buy and sell positions often. This reduces the amount of capital gains the fund generates, so the tax burden might be less in an index fund than in an actively managed mutual fund.
- Diversification: An index will often include a broad range of securities, providing diversification for the investor. This limits the risk relative to purchasing individual stocks.
An investor should understand a few basic investment terms related to index funds:
|Investing In Index Funds: A Glossary of Terms|
|Bond||A debt security
A bondholder lends money to the institution issuing the bond. At maturity, the debt is repaid, with interest.
|Capital Gain||The profit when an investment sells for more than the investor paid for it|
|Diversification||Spreading your money among different kinds of investments to reduce risk|
|Dividend||Part of a company’s profits that are paid out to shareholders on a quarterly or annual basis|
|Exchange-Traded Fund||A fund that invests in stocks, bonds or other assets and sells shares to investors
The shares are traded on exchanges, like stocks, and can be bought and sold throughout the trading day. The price fluctuates based on supply and demand.
ETFs are not mutual funds.
|Index Fund||An investment whose objective is to achieve approximately the same return as a particular market index, such as the Russell 300 Index or the S&P 500 Index|
|Market Capitalization||The value of a company determined by the share price times the number of outstanding shares|
|Market Index||The performance of a basket of stocks that represents a segment of the U.S. economy
The Dow Jones Industrial Average and the S&P 500 are market indices.
|Mutual Funds||An open-end investment company that sells shares in funds comprised of multiple stocks|
|Net Asset Value||The NAV of a mutual fund is total assets minus total liabilities. The value of a share of the fund is NAV divided by the number of outstanding shares|
|Risk||The degree of uncertainty as to the rate of return of an asset
Investors typically seek higher returns in exchange for more risk.
Learn More: 26 Investment Terms You Need To Know
If you are looking for an investment that will provide returns that are equal to, but not greater than, the general market or a subset of it, index funds could be a good option for you. But as good as they might be, you shouldn’t put all your eggs in the index-fund basket. Even though index funds provide some diversification, you should still have other investments in your portfolio. That said, index funds can certainly be an effective component of your investment strategy.
Find Out: How To Invest In the 9 Best Index Funds
Beware of confusing index funds with exchange-traded funds, or ETFs. Many index funds are ETFs, but not all, and not all ETFs are index funds. Confused? You’re not alone.
ETFs are defined by the way they are traded, not the type of investments they comprise. ETFs are traded like stocks — they are bought and sold on an exchange, and their price fluctuates, based on supply and demand, throughout the day. Mutual funds and index funds that are not ETFs are bought and sold only at the end of the day, so their prices don’t change throughout the day.
Learn More: The Complete Guide to ETFs
Index funds are a relatively inexpensive and moderate-risk way to invest. As with any investment, the decision to purchase index funds should be made as part of your overall portfolio strategy. Before investing, read and understand the prospectus, and be sure you are aware of all the costs involved.
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Karen Doyle is a personal finance writer and a former financial advisor.