Index funds are a type of mutual fund or exchange-traded fund (ETF) that hold stocks or bonds to replicate a particular index. They can be a great investment for beginners, but it's important to understand how to pick the right fund, as well as the pros and cons.
Here's what you need to know about index funds and when they make sense as an investment choice.
- Index funds replicate exposure to a given index, such as the S&P 500 or Dow Jones Industrial Average.
- Index funds can hold stocks, bonds, or other types of securities.
- Index funds offer a relatively low-cost way to buy into hundreds of companies with a single transaction.
- While an index fund's performance will closely track the underlying index, you cannot outperform the index like you can with actively managed funds.
What Is an Index Fund?
An index contains a basket of stocks, bonds, or some other security. These securities are grouped according to rules, such as geographic region, the size of the business, or what the company does. You can't invest directly in an index, but you can invest in an index fund. Most index funds are either mutual funds or ETFs that proportionally invest in all of the index’s securities, although some use derivatives or otherwise deviate slightly from the index.
Examples of Index Funds
Thousands of indexes track the movements of sectors and markets on a daily basis. They're used to gauge that market’s health and performance. The Dow Jones Industrial Average is a broad market index made up of 30 blue-chip stocks. The U.S. Global Jets Index tracks the global airline industry as a sector index. The index can also act as a market's benchmark or a way to weigh performance.
Here are a few examples of index funds and what each one tracks:
- Vanguard 500 Index Fund (VFIAX): 500 of the largest companies in the U.S.
- iShares Russell 2000 ETF (IWM): 2000 U.S. small-cap stocks
- Fidelity Sustainability Bond Index Fund (FNDSX): Bonds that meet environmental, social, and governance criteria
- Global X Millennials Thematic ETF (MILN): U.S. companies gaining from millennial generation spending habits
- Direxion Work From Home ETF (WFH): U.S. companies gaining from people working at home
How To Choose an Index Fund
Define a Goal
You should weigh a few factors before buying an index fund. First, define what you want to invest in and why. What are the risks associated with that investment? How much risk are you willing to take to achieve that goal?
Another critical factor to consider is your timeline. Are you investing for a couple of months or a couple of decades? No one timeline is better than another, but some investments work better within specific timeframes.
Research Your Options
For almost any index you want to invest in, many mutual funds and ETFs will offer similar exposure. You don't need to pick the first index fund you find, and you should compare your options. Compare transaction costs of funds that cover the same sector. How much will you pay for buying, owning, and selling the fund?
You can compare many details of index funds, such as the expense ratio, tracking error, and daily trading volume.
Decide How You Will Buy the Index Fund
If you don't properly plan out a way to enter your investment, you unnecessarily risk losing money chasing every idea you have. Rather than buying as soon as you know you want to invest in something, pause to think about how you can be more strategic. For many, this means using dollar-cost averaging strategies that take the emotion out of these kinds of decisions. Others will use technical analysis to form a buying strategy.
Pros and Cons of Index Funds
Lack of flexibility
Pros of Index Funds
- Dependable performance: You should get the same return as the index, minus fund-management costs, if you invest here. Index funds have better returns than actively managed funds in most cases.
- Lower costs: An index fund’s portfolio rarely changes. This stability results in lower trading costs and taxes. The fund’s operating costs are reduced, because there’s no need to hire portfolio managers or stock researchers, or to pay commissions that arise from constant trading. Active fund costs are about 1.3%, or $1.30 for every $100 in the fund.
- Transparency: Many index funds simply hold what's in the index, so you can always see the fund's holdings. That lets you better judge an index fund’s risk based on those holdings. An index fund that's tracking the volatile oil and gas sector may be much more of a risk than a bond index fund.
- Simple diversification: You can buy slices of hundreds or thousands of companies at once rather than single stocks as you're trying to create your own portfolio. This diversification cuts back on risk. If one stock or bond is down for the day or a year, another is most likely up.
Cons of Index Funds
- Lack of flexibility: The fund typically holds the same securities, no matter the market's direction, because its purpose is to track the index. The fund manager can’t sell stocks that are underperforming, especially during a broad market decline.
- Cannot outperform: This lack of flexibility means that index funds aren't likely to post a return higher than the benchmark. You're guaranteed the index's return when the market (or sector) rallies, but you're also guaranteed the index's loss when the market falls.
- Tracking error: The difference between an index fund’s return and the performance of its parent index mirrors the costs to run a portfolio. This is called a “tracking error.” Always go for the one with a smaller tracking error when you're comparing index funds that track the same index.
- Management differences: Indexes aren't objective. They're created by companies that determine an index’s makeup. The decision-making process isn’t strongly regulated. It's not always transparent and can be influenced by overall management tactics. Sometimes the index funds and the index have the same managers, which can create a conflict.
Why Index Funds Might Be Good for You
If you're looking to diversify your investments, an index fund provides a simple solution. When someone wants to buy stocks, but they don't necessarily know which stocks to buy, they can use a broad stock index fund to gain general stock exposure with a single transaction.
Index funds can also be used to tweak your portfolio's exposure without selling anything you currently own. For example, if you own an S&P 500 index fund, but you don't think the index owns enough health care stocks, then you can buy a health care ETF to increase your exposure to that sector. Conversely, if you think the S&P 500 contains too many health care stocks, then you can use a bearish health care ETF to gain short exposure to that sector.
Why Index Funds Might Not Be Good for You
Some investors seek exposure to the stock market, while others seek to beat the market. If your goal is to make more money than the average investor, then you can't use funds that replicate the average performance of the index you're trying to beat.
There are other advantages to investing directly in individual equities or bonds. Stock ownership gives you voting rights, and you'll get dividend payments directly from the company rather than receiving the average payment across an entire sector. Individual bonds have a maturity date letting you know when your principal will be returned, while bond ETFs perpetually reinvest maturing bonds into a new bond.
Frequently Asked Questions (FAQs)
How do you invest in index funds?
You will need a brokerage or retirement account to invest directly in index funds. Once you have a way to invest, you can place a buy order for either an ETF or mutual fund that tracks your target index.
How many index funds should I own?
How many index funds you own should depend on how diversified those indexes are. If you invest in well-diversified funds, you may only need one or two. If you invest in targeted funds that track specific sectors, then you should own many funds to build a broad, diversified portfolio. You could also put the majority of your money in a well-diversified fund and save a small amount to try investing in several different targeted areas.
How much money do you need to invest in index funds?
You can start investing in index funds with as little as a few dollars. However, it's unwise to invest more than you can afford to lose, especially if you don't have emergency savings.