Index Funds Definition and Investing Basics
Index funds are a core element of many investment portfolios. In essence, index funds rise and fall in value in accordance with the market — or economy — as a whole. Index funds allow investors to see their assets appreciate as the economy grows, and weather short-term dips and fluctuations with a longer-term outlook.
Before you learn how to buy index funds, you need to understand more precisely what an index fund is, how it is built, and what you can expect from it.
Table of Contents
What Is an Index Fund?
To understand what an index fund is, you first need to grasp the concepts of mutual funds and financial indexes. A mutual fund is a portfolio of securities, such as stocks. A market index tracks the performance of specific bellwether stocks to measure the overall condition of a financial market. Index funds are most commonly a type of mutual fund.
An index fund, therefore, is an investment product which contains the securities used to calculate a market index. One of the most well-known indexes is the Standard and Poor’s 500 (S&P 500). It consists of 500 stocks from large U.S. companies (also known as large-cap stocks). An S&P 500 index fund has a portfolio that includes stocks from those 500 companies. The U.S. has many other indexes, including the Dow Jones Industrial Average, and major markets around the world have at least one index that tracks performance.
When you invest in an index fund, your profits will increase when the index goes up and decrease when it goes down. Markets fluctuate, and though growth is not guaranteed, most indexes trend upward in the long term, just as the economy as a whole grows. The S&P 500, for example, has grown by about 8% annually over the past 60 years. The general trend of modest, reliable growth in the long-term is part of why index funds are a popular way to save for retirement: it doesn’t take dramatic growth for an investment to pay off after 30-40 years.
Benefits of Index Funds
One of the main benefits of choosing an index fund is that it allows investors to hedge their investment. Stocks can perform better or worse than the overall market. Variables like industry news, company ownership, and competition can affect the performance of a company’s stock.
When you invest in an index fund, which contains a portfolio with many stocks, you are protected against one single stock performing poorly. In other words, index funds allow investors the opportunity to get exposure to a broad market without having to purchase each stock in the index separately.
All investment funds come with management fees, but index funds typically have lower costs because they do not require much management. The stocks that make up a financial index could change, but such changes are rare. A manager who oversees an index fund only needs to set up the fund and ensure that the portfolio continues to have the correct percentage of each security. Because the management is more passive than other types of mutual funds, fees are lower. Actively-managed mutual funds, on the other hand, require more buying, selling, and analysis, so the management fees are higher.
Investors must pay capital gains taxes when the manager sells securities in the portfolio. Because such sales are few and far between for index funds, such taxes aren’t as much of an issue.
An Easier Way to Invest
Some investors try to “beat the market” by choosing individual stocks that they think will perform better than average. This is part of the premise behind many mutual funds. This is a research-intensive undertaking with no guarantee of positive results. Index funds offer a simple way to get a good chance of positive returns without weeks of research and constant monitoring.
As you learn how to invest in index funds, you will realize that you have to perform your due diligence and make smart choices about which fund you choose. You probably know major indexes such as the S&P and Dow Jones, but there are many others as well. The Russell 2000 tracks small-cap stocks, and the Barclays Capital U.S. Aggregate Bond Index measures the bond market. You can also invest in foreign index funds.
How Do Index Funds Work?
Index funds contain the securities that allow it to accurately track the performance of the target index. An index fund manager may change the fund’s portfolio to increase the tracking accuracy, but such changes are rare. You purchase shares in the fund and pay all relevant fees and taxes. Your shares increase in value when the index rises relative to its position when you bought the shares.
The goal of index funds is different than actively-managed mutual funds. Rather than tracking an index, the purpose of actively managed mutual funds is to provide the best return on investment. The managers of these funds are constantly performing research and analysis and buying and selling securities to increase gains and avoid losses. As a result of all this work, the management fees are often much higher on these funds
Stock and Bond Index Fund Examples
Investors have many different options for index funds. Here are some examples:
- S&P 500: The S&P contains 500 large-cap U.S. stocks including major firms like 3M, Amazon, Coca-Cola, and Walmart. The 500 companies make up 80% of all U.S. stocks.
- Dow Jones Industrial Average: The DJIA (“the Dow” for short) has 30 large-cap stocks, including American Express, Goldman Sachs, McDonald’s, and Nike. Many of the stocks that make up the Dow are also in the S&P 500.
- Nasdaq: The Nasdaq contains 100 companies. Unlike the other major U.S. stock indices, it does not include financial companies.
- Russell 2000: Unlike the three aforementioned large-cap stock indexes, the Russell 2000 features 2000 smaller (small-cap) companies.
- Wilshire 5000: The Wilshire 5000 is an index that tracks all actively-traded stocks in the United States. Despite its name, the index currently uses about 3,500 listings.
- MSCI EAFE: This index tracks the performance of all developed markets outside the U.S. and Canada. The index includes stocks from the UK, Australia, Japan, and many countries in the E.U.
- Bloomberg Barclays Capital U.S. Aggregate Bond Index: This index tracks intermediate-term investment-grade bonds in the United States. It includes treasury bonds, corporate bonds, and mortgage-backed bonds.
- FTSE 100 Index: The Financial Times Stock Exchange 100 tracks the 100 UK stocks with the highest market capitalization. Stocks in the index include Barclays, BP, and Vodafone.
- S&P Asia 50: The S&P Asia 50 is an example of a regional index. It includes equities from Taiwan, Hong Kong, South Korea, and Singapore, and it is meant to track performances of the major economies in East Asia (except for China and Japan).
Index Fund vs Mutual Fund
An index fund can be a type of mutual fund. When investing in index funds, some investors who are unfamiliar with the concept of these funds may expect that someone will actively manage their money. Since the primary goal of an index fund is to track the target index, this is not the case.
That said, index funds and mutual funds both provide investment opportunities that do not require calculations such as company valuation or return on investment forecasts. Because they are passively managed, index funds come with lower fees and fewer capital gains tax complications.
Like all investments, putting money into index funds carries with it a certain amount of risk. Markets have recessions and spikes. However, over the long term, these peaks and valleys have historically averaged out. This consistency is why so many retirement funds and investment portfolios include an index fund.
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This post was updated September 4, 2019. It was originally published September 3, 2019.