What Are Index Funds, and How Do They Work?

What Are Index Funds?

An index fund is a type of

mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).An index mutual fund provides broad market exposure, low operating expenses, and low portfolio turnover.These funds follow their benchmark index regardless of the state of the markets.

Index funds are considered ideal core portfolio holdings for retirement accounts, such as

individual retirement accounts (IRAs) and 401(k) accounts.Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life.Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost of an index fund.

Key Takeaways

– An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.

– Index funds have lower expenses and fees than actively managed funds.

– Index funds follow a passive investment strategy.

– Index funds seek to match the risk and return of the market based on the theory that in the long term, the market will outperform any single investment.

How an Index Fund Works

“Indexing” is a form of passive fund management.

Instead of a fund portfolio manager actively

stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio whose holdings mirror the securities of a particular index.The idea is that by mimicking the index profile—the stock market as a whole or a broad segment of it—the fund will also match its performance.

There is an index and an index fund for nearly every financial market in existence.In the United States, the most popular index funds track the S&P 500.But several other indexes are widely used as well, including:

– Wilshire 5000 Total Market Index, the largest U.S.equities index

– MSCI EAFE Index, consisting of foreign stocks from Europe, Australasia, and the Far East

– Bloomberg U.S.

Aggregate Bond Index, which follows the total bond market

– Nasdaq Composite Index, made up of 3,000 stocks listed on the

Nasdaqexchange Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies

An index fund tracking the DJIA, for example, would invest in the same 30 large and publicly owned companies that comprise that index.

Portfolios of index funds only change substantially when their

benchmark indexes change.If the fund is following a weighted index, its managers may periodically rebalance the percentage of different securities to reflect the weight of their presence in the benchmark.Weighting is a method that balances out the influence of any single holding in an index or a portfolio.

Many index ETFs replicate market indexes in much the same way that index mutual funds do, and they may be more liquid and/or cost-effective for some investors.

Index Funds vs.Actively Managed Funds

Investing in an index fund is a form of

passive investing.The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio that managers described above.

Lower Costs

One primary advantage that index funds have over their actively managed counterparts is the lower management

expense ratio.A fund’s expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.

Because the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others who assist in the stock-selection process.

Index fund managers trade holdings less often, incurring fewer transaction fees and commissions.In contrast, actively managed funds have larger staffs and conduct more transactions, driving up the cost of doing business.

The extra costs of fund management are reflected in the fund’s expense ratio and get passed on to investors.As a result, cheap index funds often cost just 0.05% or less—compared to the much higher fees that actively managed funds command, typically 0.66% and sometimes higher than 1.00%.

Expense ratios directly impact the overall performance of a fund.Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds and struggle to keep up with their benchmarks in terms of overall return.

If you have an

online brokerage account, check its mutual fund or ETF screener to see which index funds are available to you.

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Better Returns?

Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds.Indeed, a majority of mutual funds fail to beat their benchmark or broad market indexes.

For instance, during the five years ending Dec.31, 2022, approximately 87% of

large-cap U.S.funds generated a return less than that of the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices.

On the other hand, passively managed funds do not attempt to beat the market.

Their strategy instead seeks to match the overall risk and return of the market, on the theory that the market always wins.

Passive management leading to positive performance tends to be true over the long term.With shorter time spans, active mutual funds do better.The SPIVA Scorecard indicates that in a span of one year, only about 51% of large-cap mutual funds underperformed the S&P 500.In other words, approximately half of them beat it in the short term.Also, in other categories, actively managed money rules.As an example, more than 35% of

midcap mutual funds beat their S&P MidCap 400 Growth Index benchmark in the course of a year.

Lower risk through diversification

Low expense ratios

Strong long-term returns

Ideal for passive, buy-and-hold investors

Lower taxes for investors

Vulnerable to market swings and crashes

Lack of flexibility

No human element

Limited gains

Example of an Index Fund

Index funds have been around since the 1970s, but have exploded in popularity over the past decade or so.The appeal of passive investing with their low fees and a long-running

bull market have combined to send them soaring.According to Morningstar Research, investors have poured more than a trillion dollars into index funds across all asset classes over the past decade.

For the same period, actively managed funds experienced hundreds of billions of dollars in outflows.

The one fund that started it all, founded by Vanguard chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost.The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance.As of Q4 2023,

Vanguard’s Admiral Shares (VFIAX) posted an average 10-year cumulative return of 204.5% vs.the S&P 500’s 205.5%, exhibiting a very small tracking error.

The expense ratio is low at 0.04%, and its minimum investment is $3,000.

Best Index Funds

|Best Index Funds (data as of Q4 2023)|

|Fund Name||Minimum Investment||Expense Ratio||10-Yr Avg.Annual Return||Morningstar Rating|

|Vanguard 500 Index Fund Admiral Shares (VFIAX)||$3,000||0.04%||11.9%||5 stars|

|Fidelity Nasdaq Composite Index Fund (FNCMX)||$0||0.03%||14.5%||4 stars|

|Fidelity 500 Index Fund (FXAIX)||$0||0.015%||11.9%||5 stars|

|Vanguard Total Stock Market Index Fund Admiral (VTSAX)||$3,000||0.04%||11.3%||3 stars|

|Schwab S&P 500 Index Fund (SWPPX)||$0||0.02%||11.9%||5 stars|

|Schwab Total Stock Market Index Fund (SWTSX)||$0||0.03%||11.2%||3 stars|

|Schwab Fundamental US Large Company Index Fund (SFLNX)||$0||0.25%||10.7%||5 stars|

|USAA Victory Nasdaq-100 Index Fund (USNQX)||$3,000||0.45%||17.0%||5 stars|

|Fidelity Total Bond Fund (FTBFX)||$0||0.45%||2.3%||4 stars|

Remember, the “best” index fund for an individual depends on personal investment objectives and risk tolerance–and relative performance will vary from period to period.Gather comprehensive details about each fund, including performance history and fund-specific risks to help make an informed decision.Additionally, it’s always advisable to consult with a financial advisor before making investment decisions.

Index Funds or Actively Managed Funds: Which is Better?

The

debate over whether index funds are better than actively managed funds is a prominent one in the investment world, with both strategies having their own merits and drawbacks.

Here’s a comparison to help understand the differences:

Advantages of Index Funds

– Lower Costs: Index funds typically have lower expense ratios because they are passively managed.There’s no need for a team of analysts and active managers, which reduces operational costs.

– Market Representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure.

This can be beneficial for investors looking for a diversified investment that tracks overall market trends.

– Transparency: Since they replicate a market index, the holdings of an index fund are generally well-known and consistent.

– Historical Performance: Over the long term, many index funds have been shown to outperform actively managed funds, especially after accounting for fees and expenses.

– Tax Efficiency: Lower turnover rates in index funds usually result in fewer capital gains distributions, making them more tax-efficient than actively managed funds.

Advantages of Actively Managed Funds

– Potential to Outperform: Active funds aim to beat the market, not just match it.Skilled fund managers may be able to achieve higher returns than the market average or the specific index.

– Flexibility: Active managers can, in theory, quickly adapt their strategies based on market conditions, potentially protecting the fund from downturns or capitalizing on short-term opportunities.

– Specialized Strategies: Active funds can focus on specific investment strategies, sectors, or themes that might not be well-represented in a market index.

– Risk Management: Active management allows for dynamic risk assessment and management, which can be a crucial factor in volatile or down markets.

Overall, index funds have many virtues that are well-suited for ordinary long-term investors.That said, neither type of fund is inherently better than the other.It largely depends on individual investment objectives, the investment environment, and personal preferences.Diversifying across both types of funds can also be a viable strategy for many investors

How To Start Investing in Index Funds

Investing in index funds is a straightforward process, ideal for both new and experienced investors.Here’s a guide to get you started:

– Choose an Investment Platform: Begin by selecting an online brokerage or investment platform.

Today, many online platforms offer commission-free trading in index funds and ETFs and list a large array of them.

– Open an Account: Once you’ve chosen a platform, you’ll need to open an account.This typically involves providing some personal information, setting up login credentials, and completing a questionnaire about your investment goals and risk tolerance.

– Fund Your Account: After your account is set up, you’ll need to deposit funds.This can usually be done through a bank transfer.The amount you start with depends on your financial situation and investment goals.

– Select Your Index Funds: Index funds track various market indexes, like the S&P 500 or Nasdaq 100.

Research different funds to understand their performance history, management fees, and the index they track.Consider diversifying your portfolio by investing in multiple index funds.

– Purchase Shares: With your account funded, you can now buy shares of your chosen index funds or ETFs.Most platforms allow you to purchase shares directly through their website or app with just a few clicks.

– Monitor and Adjust as Needed: Regularly check on your investments.While index funds are typically long-term investments, it’s wise to review your portfolio periodically to ensure it aligns with your financial goals.

For a more detailed guide and additional resources on online brokers, visit Investopedia’s guide to the best online brokers:

Investopedia’s Best Online Brokers Guide.

This resource provides comprehensive information and comparisons to help you make an informed decision about where to open your investment account.

How Do Index Exchange-Traded Funds (Index ETFs) Work?

Index funds may be structured as exchange-traded funds (

index ETFs).These products are portfolios of stocks that are managed by a professional financial firm, in which each share represents a small ownership stake in the entire portfolio.For index funds, the goal of the financial firm is not to outperform the underlying index but to match its performance.If, for example, a particular stock makes up 1% of the index, then the firm managing the index fund will seek to mimic that same composition by making 1% of its portfolio consist of that stock.

Are Index Funds Better Than Stocks?

Index funds track portfolios composed of many stocks.

As a result, investors benefit from the positive effects of

diversification, such as increasing the expected return of the portfolio while minimizing the overall risk.While any individual stock may see its price drop steeply, if it is just a relatively small component of a larger index, it would not be as damaging.

Are Index Funds Good Investments?

Most experts agree that index funds are very good investments for long-term investors.They are low-cost options for obtaining a well-diversified portfolio that passively tracks an index.Be sure to

compare different index funds or ETFs to be sure you are tracking the best index for your goals and at the lowest cost.

But, like any investment in the stock market, index funds are subject to market risk.The value of the fund will go up or down with the index it tracks.And, since they follow an index, these funds don’t pivot in response to market changes, which can be a disadvantage in declining markets.

Thus, while index funds are generally heralded as a sound investment, their suitability depends on an investor’s goals, risk tolerance, and investment timeline.

How Much Should You Pay for an Index Fund?

Index funds generally have low annual fees, and these fees, on average, have been declining over the past several years.As of the latest data (2022), the average fee for an index fund stands at just 0.04%, with several index funds offering even lower expense ratios.

All else equal, you may want to choose the lower-cost fund if they both faithfully track the same index.(Actively-managed funds, in contrast, average 0.66%).

The Bottom Line

Index funds are a popular choice for investors seeking a low-cost, diversified, and passive investment strategy.

They are designed to replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing, such as in retirement accounts.These funds typically have lower expense ratios compared to actively managed funds, owing to their passive management style, resulting in fewer transaction fees and operational costs.

While they offer advantages like lower risk through diversification and strong long-term returns, index funds are also subject to market swings and lack the flexibility of active management.Despite these limitations, index funds are often favored for their consistent performance and have become a staple in many investment portfolios.As always, each investor should consider their personal investment objectives and risk tolerance when choosing an index fund, and consulting a financial advisor for personalized advice is recommended.

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