What Is an Index Fund and Should I Buy One?
Index funds are mutual funds that seek only to mirror the performance of an underlying stock market index — not to outperform it. Millions of investors hold them in their portfolios because they provide an easy, one-and-done way to mitigate the risk that is inherent to stock picking. That’s because index funds allow investors to spread their money across dozens, hundreds or even thousands of companies instead of placing all-or-nothing bets on individual securities.
Read: 5 Things You Must Do When Your Savings Reach $50,000
Investors flock to index funds for their low fees, the instant diversification they provide and their record of generating sustainable long-term gains. 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.
How Does an Index Fund Actually Work?
An index fund is a type of mutual fund that doesn’t require a fund manager to hand-pick securities and make decisions about how to spend the pooled money of many investors. With an index fund, the stocks are pre-selected to mirror a specific segment of the larger market. It’s called passive management, and it’s much more cost-effective, because it eliminates the high fees and commissions that professional money managers command.
What Index Funds Are Ideal For
- Retirement accounts
- Average investors with hands-off strategies
- Reducing risk over the long term
Is an Index Fund a Good Investment?
Index funds work by matching — or tracking — the performance of a stock market index.
An index is a group of stocks that share similar traits. For example, the S&P 500 index represents the 500 largest publicly traded U.S. companies. The Russell 2000, on the other hand, tracks the 2,000 smallest companies on the Russell 3000 index.
One investor might want the stability and familiarity of America’s biggest brand-name corporations. Another investor with a higher tolerance for risk might seek the greater growth potential of small companies that are still gaining traction.
In either case, both investors could gain broad exposure to all the stocks they want with the purchase of a single index fund.
A Deeper Explanation of Index Funds
Index funds are not limited to stocks. 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.
Good To Know
When the fund’s underlying index performs well, so does the fund. Whether it’s biotech or mid-cap stocks, the fund will never do better or worse than the index as a whole. Over time, this is less risky than purchasing individual stocks, but it also limits short-term growth potential. One biotech stock, for example, could gain 20% in a single day, but that growth will be tempered by the performance of many other stocks in the fund — likewise, if it loses 20%.
What an Index Fund Does Not Do
It’s helpful to understand what an index fund does not do, so you know what to expect. Index funds do not:
- Enjoy all the gains or suffer all the losses of a single security
- Beat the market
- Allow for active trading
What Is an Example of an Index Fund?
There are many types of index funds, ranging from broad market funds that track the entire stock market to specific sector funds that mirror just a tiny segment of a particular industry.
The following are some of the top index funds:
- Fidelity ZERO Total Market Index Fund — FZROX
- Fidelity Total Market Index Fund — FSKAX
- Vanguard Growth Index Fund ETF — VUG
- Vanguard Russell 3000 Index Fund — VRTTX
- Schwab Total Stock Market Index — SWTSX
What Is the Most Successful Index Fund?
On Sept. 9, 1976, the Vanguard Group started the index investing revolution when it launched the Vanguard 500 Index Fund (VFIAX) — that was 17 years before State Street debuted the world’s first ETF — also an S&P 500 index fund — in 1993. According to the American Enterprise Institute, by 1998, the fund had outperformed 97% of actively managed mutual funds, all of which had much higher fees.
By the time VFIAX turned 40 in 2016, it had lowered its expense ratio by 88% and was a staple of millions of portfolios. Today, its expense ratio is a minuscule 0.04%, and it remains one of the biggest index funds on the market.
Pros and Cons of Index Funds
It helps to understand the benefits and drawbacks before investing in index funds. Here are some index fund pros and cons.
Pros
Index funds have some advantages over other types of investments.
- They are easy to understand. The securities in a traditional mutual fund are subject to change at the whims of the fund’s manager. With index funds, if you know what’s in the index, you know what’s in the fund.
- 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 wide 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. Since index funds are passively managed, they typically have much lower fees than actively managed mutual funds.
Cons
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?
All index funds and nearly all ETFs follow the same investing strategy — passive investing designed to mirror the performance of an underlying index. But there are a few key differences that should steer your investment decisions.
Index Fund vs. ETF
- The biggest difference is that ETFs trade in shares on the open market just like stocks — you can buy and sell shares at will throughout the trading day. Index funds, on the other hand, trade only once per day when the market closes.
- The other key difference is minimum investment thresholds. You can buy an ETF for the cost of a single share or, if your brokerage allows partial-share investing, even less. Index funds, on the other hand, typically have higher minimums. VFIAX, for example, requires an investment of at least $3,000.
- 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.
Who Index Funds Are Best For
Index funds might be right for you 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
Now Might Be a Good Time to Buy an Index Fund
The “best time” to make any investment depends on your goals, strategy and financial situation — but the current bear market presents a unique opportunity. Analysts disagree on whether the market has hit its bottom, but many stocks — and therefore many index funds — are “on sale,” and trading well off their previous highs. That gives investors a chance to buy low and have their money in play when the inevitable recovery sets in and values start to rise once more.
Karen Doyle contributed to the reporting for this article.
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