What Are Index Funds?

What Are Index Funds?

Index funds use a passive investing strategy and trade less frequently to keep costs low. Let me explain what they are: index funds mirror the performance of benchmarks like the S&P 500 and other market indexes by mimicking their makeup. They invest in the same assets using the same weights as the target index, typically stocks or bonds, providing you with broad market exposure and diversification across various sectors and asset classes.

These passive investments attract many investors like you. In 2021, passive index funds tracking market benchmarks accounted for just 21% of the U.S. equity fund market, but by 2023, they had grown to about half of all U.S. fund assets.

How Index Funds Work

If you're interested in the stocks of an economic sector or the whole market, you can find indexes that aim to gain returns that closely match the benchmark index you want to track. Broader index funds can minimize tracking errors, which is the difference between the fund's performance and the target index.

The portfolios of index funds only change substantially when their benchmark indexes change. If the fund follows a weighted index, its managers may periodically rebalance the weights and components of their fund's securities to keep matched up with the target index.

For broad indexes like the S&P 500, it would be impractical or expensive for you to construct the right proportions in a portfolio. Index funds do the work by holding a representative sample of the securities. S&P 500 index funds, the most popular and oldest such funds in the U.S., mimic the moves of the stocks in the S&P 500, which covers about 80% of all U.S. equities by market cap.

Popularity

The rise of passive funds has been seismic because they often outperform their actively managed peers. According to the S&P Indices Versus Active scorecards, about 9 out of 10 actively managed funds didn't match the returns of the S&P 500 benchmark in the past 15 years.

Besides the S&P 500, other major indexes followed by such funds include the Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, which follows the total U.S. dollar-denominated bond market; and the Dow Jones Industrial Average, consisting of 30 large-cap companies chosen by the editors of the Wall Street Journal.

You should review a fund's fees and performance before investing. As of August 2024, Fidelity's Nasdaq Composite Index Fund (FNCMX) had a 10-year average annual return of 15.54% versus 15.57% for the Nasdaq composite, a 0.03% difference.

Are Index Funds Good Investments?

There are good reasons why these funds appeal to investors. Index funds are a low-cost way to track a specific group of investments, which can be more broadly diversified than individual stocks and simpler to buy than each of the individual holdings within the index. They are very popular for people looking to invest in a group of investments in a simple and cost-effective way.

Index funds often have low expense ratios. In bull markets, these funds can provide attractive returns as the market rises. They do come with disadvantages, however—one is the lack of downside protection; in prolonged downtrends, these funds can perform poorly in line with the broader market.

For you considering index funds, there are two main ways to do so: self-directed research, which involves educating yourself on index fund investing principles, staying informed about market trends and tax implications, and regularly reviewing and adjusting your portfolio; or seeking professional advice, where consulting with a financial advisor can guide you in selecting a fund based on a broad understanding of your portfolio and ensure your choice aligns with your overall financial goals.

Investors in index funds can often benefit from professional guidance, despite index funds' reputation as a do-it-yourself investing solution. Advisors are able to help with compiling a portfolio of multiple index funds that track multiple markets, say a U.S. large-cap index fund, an international stock index fund, and perhaps a U.S. and International Bond Index Fund. This diversification strategy can help spread risk across different markets and asset classes. These portfolios should be monitored for rebalancing to ensure no portion gets over or underweight.

The need for professional advice is more apparent when your finances are complex. An advisor can be especially helpful if the account is taxable or if there are irregular contributions to an account. Otherwise, there could be tax efficiencies left on the table or the account could get more out of balance than preferred if there are no recurring contributions being put in to keep it rebalanced.

While index funds are, for many, a straightforward investing approach, they're not a one-size-fits-all solution, and thousands of choices are available. The decision to invest in index funds—and how to manage them as part of a wider portfolio—should be based on your financial situation, goals, and risk tolerance. Whether you choose to go it alone or seek professional guidance, understanding the pros and cons of index fund investing is crucial to making informed investment decisions.

How to Invest in Index Funds

Investing in index funds is straightforward for both new and experienced investors. Here's how you can get started: Choose your investment platform by selecting an online brokerage or investment platform—some of the best provide strong customer support, robust research, and analytical tools. Open and fund an account by providing personal information, setting up login credentials, and completing a questionnaire about investment goals and risk tolerance, then deposit funds through a bank transfer. Select an index fund by researching different funds to understand their performance history, management fees, and the indexes they track—consider diversifying your portfolio by investing in several index funds. Buy shares with your account funded, purchasing directly through the platform's website or app with just a few clicks. Monitor and adjust as needed, since while index funds are typically long-term investments, it's wise to review your portfolio periodically to ensure it aligns with your financial goals.

Benefits of Index Funds

The primary advantage index funds have over their actively managed peers is lower fees. If actively managed funds don’t outperform their passive peers, you might ask why we're paying fund managers so much more in fees each year. Using SPIVA data, 79% of actively traded funds had underperformed the S&P 500 the previous five years, and over 15 years, it's 88%.

A greater public understanding of this data helps explain the growing popularity of passive funds, almost all of which are index funds. You still have to pay an expense ratio with these funds, charged as a percentage of the assets under management to cover costs. Since the managers of index funds are simply replicating the performance of a benchmark index, they don't need research analysts and trade holdings less frequently, meaning fewer fees. By contrast, actively managed funds have large staffs and conduct trades with more volume, driving up costs. As such, index funds can charge less, often as low as 0.04%, compared with actively managed funds at 0.44% or higher.

To summarize the advantages: lower costs because index funds typically have lower expense ratios as they are passively managed; market representation as they aim to mirror the performance of a specific index, offering broad market exposure; transparency since they replicate a market index and the holdings are well-known; historical performance where over the long term, many index funds have outperformed actively managed funds after fees; and tax efficiency due to lower turnover rates resulting in fewer capital gains distributions. These funds have many virtues that make them well-suited for ordinary long-term investors. That said, the best choice for you—active or passive—depends on your financial goals, the investment environment, risk tolerance, and other specifics about your situation.

Drawbacks of Index Funds

Among the critiques of index funds is their inherent lack of flexibility. Because they are designed to mirror a specific market, they decline in value when the market does, and they can't pivot away when the market shifts.

They are also criticized for automatically including all the securities in an index, which means they may invest in companies that are overvalued or fundamentally weak, leaving aside greater weighting of assets that could provide better returns. Of course, this automated strategy has often outperformed active management, perhaps in part by holding onto assets that active fund managers have misjudged.

Another disadvantage has to do with market-cap weighting, which many index funds use. Companies with higher market capitalizations have a more significant influence on the fund's performance in such funds. This concentration can lead to being too tied to the fate of a few large companies, magnifying your risks if these companies underperform.

Index Mutual Funds vs. Index ETFs

If you're interested in index funds, you'll likely have to choose between investing in mutual funds or ETFs that track specific indexes. Both types replicate the performance of a specific market index, but they differ in several key aspects that can influence which to choose.

Index mutual funds pool money to buy a portfolio of stocks or bonds. You buy shares directly from the mutual fund company at the net asset value price, calculated at the end of each trading day. Among the main advantages are the simplicity of automatically reinvesting dividends and dollar-cost averaging, the practice of making regular set contributions.

Index ETFs, meanwhile, are traded on exchanges like individual stocks. This lets you employ far more trading strategies, like timing ETF share trades, using limit or stop-loss orders, and short selling.

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 fund that started it all, founded by Vanguard chair John Bogle in 1976, remains among the best as judged by its long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully in composition and performance. As of July 2024, Vanguard’s Admiral Shares (VFIAX) had a 10-year average annual return of 13.11% vs. the S&P 500’s 13.14%—a very small tracking error. The expense ratio is low at 0.04%, and its minimum investment is $3,000.

Are Index Funds Better Than Stocks?

Index funds track portfolios composed of many stocks or bonds. As a result, you 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's a relatively small part of a larger index, it won't be as damaging.

How Much Does It Cost to Invest in an Index Fund?

Many index funds have no minimum required to start investing. Index funds also generally have low annual fees, and these fees, on average, have been declining over the past several years. According to data from the Investment Company Institute in 2024, the average fee for an index fund is 0.05%, with some index funds offering even lower expense ratios. All else being equal, you might wish to choose the lower-cost fund among those that equally track the same index well.

Are Index Funds Good for Beginners?

Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified. Index funds have lower expense ratios than most actively managed funds, and they often outperform them, too. These reasons make them a solid choice not only for beginners but for many expert investors as well. A final bonus for newer investors: If your fund is tied to a leading index like the S&P 500 or Nasdaq composite, you'll see news coverage often, helping you keep abreast of your investment while learning the broader market's ebbs and flows.

Are Index Funds Safer Than Stocks?

Index funds are generally safer than individual stocks because of their inherent diversification. They track a specific market index, such as the S&P 500, which means they contain a broad range of stocks across various sectors. If a single company performs poorly, that hurts you if that's a big part of your portfolio. But if it's the S&P 500 index, it's just one of hundreds in your index fund.

What Are the Best Index Funds for Retirement?

The best index funds for retirement offer growth potential and solid risk management that aligns with your time to retirement and risk tolerance. For long-term growth, consider broad-market equity index funds like the Vanguard Total Stock Market Index Fund (VTSAX) or the Fidelity 500 Index Fund (FXAIX). For diversification and income, bond index funds like the Fidelity Total Bond Fund (FTBFX) can be a good choice. Target-date retirement funds, which automatically adjust their allocation as your retirement approaches, can also be a convenient option for retirement planning, though these are actively managed and invest in a range of indexes and other assets.

The Bottom Line

Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds. 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 retirement accounts. While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management. Despite these limits, index funds are often favored for their consistent performance and are now a staple in many investment portfolios. Consider your investment objectives and risk tolerance when choosing an index fund. Talking first with a financial advisor for personalized advice is always prudent.