What is an Index Fund?
A plain English explanation of index funds and why they are so popular in the FIRE community.
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If you're somewhat new to investing, the term "index fund" sounds scarier than it actually is. An index fund aims to track or mirror the performance of a particular financial market index.
For instance, you’ve likely heard of the S&P 500, which is just an index that measures the performance of the 500 biggest companies in the United States. Easy, right? Analysts use this index as a gauge for how the market is performing as a whole.
So when you invest in an S&P 500 index fund, you’re essentially investing in 500 different companies instead of just buying stock in one individual company.
Of course, there are many different types of index funds that track different indexes. Each particular fund’s portfolio will include the stocks, bonds, or securities that make up the index, allowing the fund to follow a trajectory that’s as close as possible to the index itself.
How an Index Fund Works
The index fund will attempt to replicate a specific index as closely as possible. If the holdings of the index fund are identical to the assets that make up the index, the performance of the fund will mirror the performance of the index itself.
There are many different indexes, but some of the popular options include:
- S&P 500
- Dow Jones Industrial Average (DJIA)
- Wilshire 5000 Total Market Index
- Russell 2000
The S&P 500 is the most popular index for index funds to track, so let’s use it as an example. A well-known index, the S&P 500 measures the performance of about 500 U.S.-based companies across many different sectors. The S&P 500 is often used as a measuring stick for the U.S. stock market as a whole. An index fund would try to replicate the performance of the S&P 500 by owning shares of all companies that are currently included in the S&P 500.
As an investor, when you own shares in an S&P 500 index fund, you indirectly own a small portion of all of the roughly 500 companies that make up the index.
Here's an illustration from our friends at Personal Finance Club:
Examples of Index Funds
There are far too many different index funds to cover them all here, but we’ll take a look at a few popular options as examples of what’s available.
Vanguard Total Stock Market ETF (VTI) - This ETF tracks the CRSP US Total Market Index. While index funds that track the S&P 500 or the Dow Jones Industrial Average are focused on larger companies and blue-chip stocks, VTI provides greater diversity by including large-cap, mid-cap, and small-cap equities.
SPDR S&P 500 ETF (SPY) - There are many ETFs that track the S&P 500, but SPY is the most popular.
iShares Russell 2000 ETF (IWM) - If you want exposure to small public U.S. companies, an index fund, like IWM, that tracks the Russell 2000 is a solid option.
Why Are Index Funds Popular?
Index funds are investment products of choice for several reasons, including:
- Diversification - With a single investment, you’ll get a portfolio of securities that provides some level of diversification. Rather than investing in a single company, you’ll have a portfolio as diverse as the index it’s tracking.
- Low Cost - The expense ratios of index funds tend to be very low. The less money you pay in management fees, the more you’re able to keep in the investment.
- Strong Performance - Historically, index funds have performed very well. “Beating the market” is extremely difficult. Following the market instead of attempting to beat it will often produce better results.
- Ease and Convenience - Index funds make investing simple. There aren’t a lot of decisions to make. Simply choose the index fund you prefer, and then continue to purchase more shares whenever you’re able.
Passive Investing With Index Funds
One of the main reasons why many people don’t invest in the stock market is because they don’t feel like they know enough, and they’re not sure where to start. While it’s true that investing in individual companies can feel overwhelming, index funds provide an ideal alternative. Anyone can get exposure to the stock market without the need for expertise, and without taking excessive risk by choosing an index fund.
While investing in index funds does come with some level of risk, it’s much different than purchasing shares of individual stocks. If you’re a long-term investor, your investments in an index fund should increase in value over time. For example, the S&P 500 may fluctuate up and down, but if you’re investing with a 20-30 year timeframe, it’s almost certain to increase significantly, regardless of the ups and downs along the way.
You don’t need to be financially savvy to invest in index funds, and you don’t need to spend time analyzing reports and data. Passive long-term investors can put money into an index fund and then continue to add money as they’re able. It’s one of the easiest ways for anyone to invest, but it still provides the opportunity for excellent gains.
Do Index Funds Have Fees?
Yes, most index funds do have some fees, but they’re typically very low. For example, the Vanguard Total Stock Market ETF has an expense ratio of just 0.03%. That means if you have $100,000 invested, you’ll pay $30 in fees for the year. Fidelity actually has a few index funds with 0% expense ratios. While not all index funds offer fees this low, they tend to be much lower than the fees associated with actively managed funds and most other types of investments.
Are Index Funds Better Than Actively-Managed Funds?
Actively managed funds attempt to outperform the market by using the strategy of the fund manager. The expense ratios of actively managed funds will vary, but they’re almost always significantly higher than the expense ratios of index funds. In theory, it seems like an actively-managed fund would be able to produce better results than an index fund that tracks a specific index, but that’s often not the case.
Some fund managers are able to outperform the market for a short time, but beating the S&P 500 or the total stock market over a long period is an extremely difficult task, and most actively managed funds come up short.
Overall, many investing experts prefer simple index funds because they usually come out on top in the long run, and because the expense ratios are so low.
Things to Consider When Investing in Index Funds
If you’re interested in investing in index funds, the next step is to choose the fund that’s right for you. Here are some questions to ask yourself:
What Is Your Timeframe?
Are you a long-term investor saving for retirement, or are you likely to need this money within the next few years? Your timeframe will influence the type of index fund you choose. Those with longer timeframes can afford to choose an investment that may be more likely to fluctuate in the short-term, but also more likely to produce larger gains over the long-term.
If you’re in your 20s or 30s and saving for retirement, you’ll want an investment that gives you the best potential for long-term growth. But if you’re 60 years old and looking to retire in the next few years, you may prefer to take a more cautious approach. An index fund that focuses on large-cap stocks is generally considered a lower risk investment than an index fund that focuses on small-cap stocks, but that small-cap index fund might provide better growth over a longer period of time.
What Is Your Target Return?
How much are you looking to gain from your investment? If you’re after higher returns, you’ll need to be willing to accept higher risk. If you’re after a more moderate return, you can choose an index fund that also comes with moderate risk.
What Else Is in Your Portfolio?
Index funds provide a level of diversification, but some funds are more diverse than others. You may want to invest in more than one index fund to get added diversification. For example, if you invest in a fund that tracks the Russell 2000, you’ll have exposure only to small company stocks. You could get added diversification by putting some of your money into a fund that tracks the S&P 500, which will give you exposure to large blue-chip companies as well.
Frequently Asked Questions
Is now a good time to buy index funds?
For long-term investors, it’s always a good time to buy index funds. Regardless of short-term fluctuations in the market, indexes should go up over the long-term. That means that if you’re investing with a 10, 20, or 30 year time frame in mind, you shouldn’t be worried about what the market is doing right now.
What are some risks of index funds?
The value of index funds can rise or fall in the short-term. However, the risk is relatively low for long-term investors since the index itself should rise with time.
Another risk is the possibility of missing out on other investments. However, over the long-term, index funds often outperform other investments.
Are index funds a good investment?
There are many different types of index funds, but in general, yes, index funds are excellent for long-term investors. If you’re saving and investing for retirement, a total stock market fund like Vanguard’s VTI will be tough to beat.
The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. This information is provided strictly as a means of education regarding the financial industry.