What Is an Index Fund and Should I Buy One?

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An index fund is a type of mutual fund that attempts to replicate the success of an index on the stock market. Index funds can be a great addition to retirement portfolios. They allow investors to put their money in the entire stock market rather than in just a few single stocks.

Investors might consider index funds if they want to match, but not outperform, the larger market. Like any investment, index funds 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.

What Is an Index Fund and How Does It Work?

An index fund is a type of mutual fund. It allows a group of people to pool together their money to purchase a group of stocks. With an index fund, the stocks are selected to mirror a specific sector of the larger market.

Index funds are ideal for:

  • Retirement accounts
  • Hands-off investing styles
  • Balancing risk

What Is In an Index Fund?

An index is a group of stocks that together represent all or part of the greater stock market. The S&P 500 consists of 500 of the largest U.S. companies traded on the exchanges. The Russell 2000 is another popular index, consisting of 2,000 smaller-cap companies.

Index funds work by matching, or tracking, the performance of a stock market index, such as the S&P 500 or the Dow Jones Industrial Average. The stocks are specifically chosen to reflect the companies in the index the fund tracks.

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Here’s a deeper index fund explanation. Vanguard’s Total Stock Market Index Fund Admiral Shares contains stocks from 10 different market sectors based on sampling of the index. Taken as a whole, the fund’s primary attributes are consistent with those of the index.

Index funds are not limited to stocks, though. Some index funds, like Fidelity’s U.S. Bond Index Fund (FXNAX), track the bond market. Others, like Vanguard’s Real Estate Index Fund (VGSIX), are based on real estate securities.

Good To Know

When the market — or the sector of the market mimicked in the fund — performs well, so does the fund. It should not outperform or underperform its index. This is less risky than purchasing individual stocks.

What an Index Fund Does Not Do

It’s helpful to understand what an index fund does not do:

  • Invest in a single stock
  • Beat the market
  • Actively trade

Index Fund Examples

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.

These funds are some of the largest index funds available:

  • Fidelity 500 Index Fund: S&P 500 Index
  • Invesco QQQ Trust Series I: Nasdaq-100 Index
  • Vanguard 500 Index Fund: S&P 500 Index
  • Vanguard Information Technology Index Fund: Technology sector benchmark

Benefits and Drawbacks of Index Funds

the advantages and disadvantages of index funds for investing

It helps to understand the benefits and drawbacks before investing in index funds. Here are some index funds pros and cons.

Advantages

Index funds have some advantages over other types of investments:

  • They are easy to understand. You purchase the index fund and let someone else manage it for you.
  • They have high liquidity. Investors can redeem shares on any business day, minus fees and charges.
  • They can diversify a portfolio. Index funds provide an opportunity to lower risk through a diverse selection of securities.
  • They are professionally managed. Most index funds are managed by a professional registered with the SEC.
  • They may have fewer fees than actively managed funds. It often costs less to manage index funds, and those savings may be passed on to investors through lower transaction fees and management costs.

Disadvantages

As with all investments, there’s risk associated with index funds.

  • They’re not flexible. You can’t pick individual stocks.
  • They can have limited gains and average returns. Index funds won’t outperform the index they track.
  • Some have high maintenance fees. High account maintenance fees can offset any savings from investing in a passively managed index fund vs. an actively managed mutual fund.
  • Tracking errors are possible. If the fund doesn’t have the right mix of stocks, it may not perform like the index it’s tracking.

What Is the Difference Between an Index Fund and an ETF?

An exchange-traded fund combines features of index funds with features of intraday trading. ETFs are not mutual funds, but index funds and ETFs are similar in many ways.

They also have distinctive differences that make each product a better choice for certain investors. Here are key differences between an index fund and an ETF:

Index Fund vs. ETF

  • The minimum initial investment to purchase an ETF is usually less than an index fund.
  • ETFs are traded like stocks with real-time pricing. This gives investors more control over their portfolio.
  • Index funds are sometimes more liquid than ETFs. Some ETFs don’t have enough demand to make them easy to sell.
  • ETFs are usually more tax-efficient than index funds. For many investors, tax liabilities for ETFs are usually lower than for index funds with similar value.

Who Are Index Funds Best For?

Index funds are a relatively inexpensive and moderate-risk way to invest. They bring returns equal to, but not greater than, the sector or market they track. Index funds can be a good investment for certain investors.

Index funds are best if you:

  • Are a beginning investor still learning about the stock market
  • Want to invest in the stock market but don’t want to buy individual stocks
  • Need to diversify your portfolio
  • Prefer an investment product with lower risk than individual stocks
  • Don’t feel the need to beat the market or sector your index fund tracks

As with all investments, index funds do come with a degree of risk. You can lose money in an index fund. Do your research and speak to a financial advisor before making investment decisions.

This article has been updated with additional reporting since its original publication.

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About the Author

Karen Doyle is a personal finance writer with over 20 years’ experience writing about investments, money management and financial planning. Her work has appeared on numerous news and finance
websites including GOBankingRates, Yahoo! Finance, MSN, USA Today, CNBC, Equifax.com, and more.