What is an index fund? A low-cost, low-risk way to invest in the stock market

Index funds1
Index funds suit investors with a long-term time horizon and a preference for a passive, buy-and-hold strategy. CasarsaGuru/Getty Images
  • Index funds are financial vehicles that pool investors’ money into a portfolio of securities that mirror a particular market index.
  • Because they are passively managed, index funds have low fees.
  • Diversified by design, index funds are relatively low-risk, but their gains tend to be slow as well.
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An index fund is a type of financial vehicle that pools investors’ money to purchase a portfolio of stocks, bonds, or other securities. This portfolio is designed to mimic a particular financial market index – a select group of securities.

An index fund can be structured as either a mutual fund or as an exchange-traded fund (ETF). The term “index fund” applies to either, but it’s often used synonymously with an ETF, since so many ETFs are index-tracking instruments.

Index funds differ from other funds on the basis of their investment strategy. This strategy is to follow its benchmark, or designated market index – generally, a broad-based one that tends to perform well over time.

There are many different indexes tracking different sectors of the market. Along with the well-known S&P 500, others include:

  • Dow Jones Industrial Average (DJIA), which is made up of 30 large-cap companies
  • Russell 2000 (RUT), which consists of 2,000 small-cap stocks
  • Bloomberg Barclays US Aggregate Bond Index, (LBUSTRUU), which consists of bonds
  • MSCI EAFE (MXEA), which is made up of foreign stocks
  • New York Stock Exchange Composite Index (NYA), which includes all common stocks listed on the NYSE

How index funds work

When you invest in an index fund, you’re buying shares in all the companies that make up the index. Most index funds are weighted by market capitalization – the total dollar market value of a company’s shares. That means that these funds usually purchase more of the largest companies in the index than of the smallest companies.

The composition of the benchmark index determines the trading decisions of an index fund. By design, true index funds must follow their index. That means there is no room for fund managers to make decisions about which trades to make. Rather than actively picking stocks, they are practicing passive management.

Index funds are also referred to as “passive funds” or “passively managed funds.”

Some funds, called “active index funds,” largely follow an index but also allow the fund manager to choose to buy certain other individual stocks or sell others.

These are not true index funds because they do not necessarily follow an index. Over time, the portfolio of these funds may differ significantly from the index the fund purportedly follows.

Benefits of index funds

Many investors, especially beginners, prefer index funds to invdividual stocks for plenty of reasons. The main benefits of index funds include:

1. Diversification means you’ll usually win.

Up to 90% of active fund managers underperform compared to their benchmark index (that is, the segment of the market they loosely follow).

And if a problem for the pros, imagine what it’s like for the amateur investor. “Trying to pick winners, for most, is a loser’s game,” says Robert R. Johnson, Professor of Finance at Creighton University. “The solution is to invest in diversified funds.”

An index fund provides you with a diversified portfolio of stocks that, as a group, usually do well over time. For example, the Vanguard 500 Index Fund (the one that started it all) has seen a 5-year average return of 11%.

2. They are cost-effective

Diversification can be expensive to pursue by yourself with individual investments. Index funds offer more bang for the buck – a single purchase into its pooled portfolio makes your diversification more cost-effective. Some funds have minimums as low as $US1 ($AU1).

3. They are passively managed

Many casual investors aren’t interested in managing their investment; they just want to steadily grow their money. Index funds don’t require any decisions, so they’re great for hands-off investors.

4. They have the lowest costs and fees

Index fund managers don’t make many investment decisions, so they don’t need to hire researchers or analysts. Those cost savings are passed on to investors through lower management fees and costs. The average expense ratio of an index fund is around 0.49% and some are as low as 0.03%.

Disadvantages of index funds

Index funds also come with disadvantages and risks:

1. They’re not great for short-term gains

A diversification strategy limits how much you lose if a single stock tanks, but it also limits your opportunities to gain on well-performing stocks. That’s why index funds don’t see the big upswings that some investors are hoping for.

If you’re looking to speculate on a skyrocketing star, you’ll want another type of product (perhaps penny stocks).

2. They’re vulnerable to the market

By their nature, index funds are tied to their index. If the benchmark is dropping, so will the value of your index fund investment.

And management’s hands are tied. “Index portfolio managers typically can’t deviate from the index holdings-even to take advantage of trends or market mispricings,” says Tricia Rosen, Principal at Access Financial Planning. And they can’t exclude holdings that are over-valued, either.”

3. They may not be as diversified as they appear

Brian Berkenhoff of Birch Investment Management notes that “an investor who has $US1 ($AU1),000,000 in an S&P 500 index fund would seem to be diversified by owning 500 stocks. However, because most index funds weight investment by market capitalization, $US220,000 ($AU295,003) of that might be invested in just five companies.”

Case in point: The top five companies in the S&P 500 are Apple, Microsoft, Amazon, Facebook, and Alphabet – all players in the tech sector. So if that sector tanks….

Before you invest in index funds

Rosen suggests that anyone considering an index fund should read the fund’s prospectus to understand:

  • What index the fund follows. There are many different indexes and some funds use a blend of indexes.
  • How rigidly the fund follows the index. True index funds rigidly follow the index, but some allow portfolio managers to deviate from the index to try to increase returns.
  • The fund’s fees and expense ratio. Typically these are low. But they may be higher in funds where the portfolio manager is allowed to do more active trading.

The financial takeaway

Index funds are popular because they are a low-risk, low-maintenance, low-cost way to see steady returns over time. But no investment is one-size-fits-all. To see if they suit you, ask yourself:

  • Am I looking to invest for the future? Index funds are best suited for investors with a long-term horizon: While the market historically rises over time, you do need time to weather the bumps..
  • Am I the buy-and-hold type? Index funds are ideal for those who aren’t interested in picking stocks.
  • Am I comfortable with slow gains? Index funds typically perform better than actively managed funds over time, but gains are usually moderate. Actively managed funds can sometimes see higher returns in the short-term.

Any investment has some risk attached to it, of course. But index funds rank fairly low on the risk spectrum – and are certainly more cost-effective than trying to buy stocks on your own.

“Investors simply can’t afford to make oversized bets on individual securities,” says Johnson. “Investing in a broadly diversified basket of securities is a more prudent strategy.”

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