What are index funds? How do they works? Explained for beginners
Discover how index funds function, offering beginners a straightforward way to invest in a diversified portfolio mirroring the market's performance.
Index funds seek to replicate the performance of benchmarks such as the S&P 500 by imitating their composition. These passive investments, once viewed as unexciting, have sparked a significant shift in U.S. equity markets, attracting a growing number of investors and funds. The statistics reveal this transformation: in 2012, passive index funds tracking market benchmarks represented only 21% of the U.S. equity fund market. However, by 2024, passive funds had surpassed 50% of assets, outpacing actively traded counterparts.
The significant change has occurred as index funds have consistently outperformed actively managed funds. According to the widely referenced S&P Indices Versus Active (SPIVA) scorecards, approximately 90% of actively managed funds failed to match the returns of the S&P 500 benchmark over the preceding 15 years. Critics argue that rather than possessing unique stock-picking abilities, managers of actively traded funds have primarily succeeded in charging higher fees while delivering lower returns to clients. Regardless of the ongoing debates regarding fund performance, many investors who once believed in the value of these fees for actively managed funds now perceive them differently, as the allure has clearly faded.
To understand the reasons behind this shift, we delve into the definition and mechanics of index funds. Throughout, we'll explore the advantages and disadvantages of constructing a portfolio with index funds.
Main points
- Index funds employ a passive investment approach, focusing on long-term strategies without actively selecting securities or timing the market.
- Mutual funds and exchange-traded funds (ETFs) offer various types of low-cost index funds.
- An index fund is a collection of stocks or bonds structured to replicate the composition and returns of a financial market index.
- These funds typically incur lower expenses and fees compared to actively managed funds.
- The goal of index funds is to mirror the risk and return of the market, based on the belief that over time, the market will surpass individual investments.
What are Index funds?
Indexes and index funds cover nearly every aspect of the financial market. Index funds invest in the same assets, using the same allocations as the target index, which usually consists of stocks or bonds. Whether you're interested in a specific economic sector or the entire market, there are indexes designed to closely replicate the returns of the benchmark index you wish to monitor. Index funds employ a passive investment strategy, minimizing trading activity to maintain low costs.
Index funds simplify the process of investing in broad indexes like the S&P 500, which would otherwise be impractical or expensive to replicate individually. These funds achieve this by holding a representative sample of the securities within the index. S&P 500 index funds, widely popular in the U.S., closely track the performance of the stocks in the S&P 500, covering approximately 80% of all U.S. equities by market capitalization.
The composition of index fund portfolios undergoes significant changes only when their benchmark indexes experience alterations. If a fund tracks a weighted index, its managers may periodically adjust the weights (expressed as a percentage by market capitalization) and components of the fund's securities to maintain alignment with the target index.
In addition to the S&P 500, index funds replicate other major indexes such as the Nasdaq Composite Index, comprising 3,000 stocks listed on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, tracking the entire U.S. dollar-denominated bond market; and the Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies selected by the editors of the Wall Street Journal.
Index funds offer broad market exposure and diversification across various sectors and asset classes based on their underlying index. These broader index funds are generally effective at minimizing tracking errors (the variance between the fund's performance and the target index). However, it's essential to thoroughly evaluate the fees and performance of any fund before investing. For instance, as of March 2024, Fidelity's Nasdaq Composite Index Fund (FNCMX) had an average annual return of 15.16% over ten years, compared to 15.23% for the Nasdaq composite, indicating a difference of only 0.07%.
Benefits of Index funds
Index funds offer a significant advantage over actively managed funds primarily due to their lower fees. As actively managed funds struggle to outperform their passive counterparts, investors are questioning why they should pay higher fees for these funds. Data from SPIVA, which compares the performance of actively managed funds to certain benchmarks, indicates that 87% of actively traded funds underperformed the S&P 500 over the previous five years (as of mid-2023), increasing to 92% over a 15-year period.
The increasing public awareness of statistics like these explains the growing popularity of passive funds, the majority of which are index funds. While investors still incur an expense ratio with these funds—a percentage of assets under management used to pay advisors, managers, and cover fees—index fund managers simply replicate the performance of a benchmark index without the need for research analysts or complex trading strategies. Consequently, index funds trade holdings less frequently, resulting in lower transaction fees and commissions compared to actively managed funds.
Given their simplified management approach, index funds can charge lower fees, typically around 0.05% or less, compared to the higher fees of actively managed funds, often ranging from 0.44% to over 1.00%, depending on the assets.
What do these fees provide? Passively managed index funds aim to match rather than beat the market. Their advantages include lower costs due to passive management, broad market representation, transparency in holdings, historically favorable performance compared to actively managed funds after accounting for fees, and tax efficiency resulting from lower turnover rates.
These virtues make index funds suitable for ordinary long-term investors. However, the optimal choice—whether active, passive, or any fund—depends more on individual financial goals, risk tolerance, and specific circumstances than on general characteristics.
Drawbacks of Index funds
One criticism of index funds relates to their inherent inflexibility. Since they aim to replicate a specific market, they experience declines when the market does, lacking the ability to adjust in unfavorable conditions. Moreover, they are faulted for automatically including all securities in an index, potentially investing in overvalued or weak companies. This automated approach, however, has often surpassed active management by retaining assets that active fund managers misjudged.
Additionally, index funds utilizing market-cap weighting face a drawback. These funds give more weight to companies with higher market capitalizations, meaning that the fund's performance is heavily influenced by a few large companies. This concentration increases the risk of underperformance if these companies fail to meet expectations.
Best Index funds
| Fund Name | Minimum Investment | Expense Ratio | 10-Yr Avg. Annual Return |
|---|---|---|---|
| Vanguard Total Stock Market Index Fund Admiral (VTSAX) | $3,000 | 0.04% | 12.06% |
| Vanguard 500 Index Fund Admiral Shares (VFIAX) | $3,000 | 0.04% | 12.60% |
| Fidelity 500 Index Fund (FXAIX) | $0 | 0.015% | 12.69% |
| Fidelity Nasdaq Composite Index Fund (FNCMX) | $0 | 0.29% | 15.16% |
| Schwab Total Stock Market Index Fund (SWTSX) | $0 | 0.03% | 12.00% |
| Schwab S&P 500 Index Fund (SWPPX) | $0 | 0.02% | 12.73% |
| Schwab Fundamental US Large Company Index Fund (SFLNX) | $0 | 0.25% | 11.36% |
| Fidelity Total Bond Fund (FTBFX) | $0 | 0.45% | 2.28% |
| USAA Victory Nasdaq-100 Index Fund (USNQX) | $3,000 | 0.44% | 17.97% |
Index Mutual funds vs Index ETFs
If you're considering index funds, you'll likely need to decide between investing in mutual funds or ETFs that track specific indexes. Both types of funds aim to replicate the performance of a particular market index, but they differ in several key aspects that may impact your decision based on your investment objectives and strategy.
Index mutual funds pool money to purchase a portfolio of stocks or bonds. Investors acquire shares directly from the mutual fund company at the net asset value (NAV) price, which is determined at the end of each trading day. Key advantages of index mutual funds include the simplicity of automatically reinvesting dividends and dollar-cost averaging (making regular contributions at set intervals).
On the other hand, index ETFs are traded on exchanges like individual stocks, providing investors with the opportunity to utilize various trading strategies such as timing ETF share trades, employing limit or stop-loss orders, and engaging in short selling. These advantages of index ETFs offer investors greater flexibility and options in their investment approach.
Index Mutual Funds vs. Index ETFs
| Index Mutual Funds | Index ETFs | |
|---|---|---|
| Purpose | Passively mirror a designated market index, shares are purchased/sold directly through the fund company. | Passively follow a particular market index, shares are traded on an exchange. |
| Trading | Purchased/sold at the close of the trading day at net asset value (NAV). | Traded continuously throughout the day, similar to stocks. |
| Management Style | Passive | Passive |
| Pricing | The NAV is computed once daily at the close of the market. | The market price fluctuates in real-time throughout the trading day, which may slightly diverge from the NAV. |
| Fees | Usually, fees are lower compared to actively managed mutual funds, but they are often slightly higher than equivalent ETFs. | Generally low fees |
| Liquidity | Less liquid than ETFs | Highly liquid |
| Tax Implications | As mutual funds are required to distribute realized capital gains to shareholders, this could result in an annual tax obligation if gains are realized by the fund manager. However, fund managers employ strategies to mitigate this tax liability. | ETFs utilize a creation/redeeming system for creation units during rebalancing, thus avoiding exposure to capital gains that would need to be distributed. |
| Cons | Restricted trading windows, minimum investment requirements, and possibly elevated fees. | There's a possibility of wider bid-ask spreads during periods of volatility, along with trading commissions if the brokerage imposes charges for trades. |
| Pros | Convenient for dollar-cost averaging, automated reinvestment of dividends, and systematic investment of fixed amounts at regular intervals. | Intraday trading flexibility allows for implementing stop losses or limit orders to manage risk, and they can be purchased in individual shares for accessibility in terms of pricing. |
| Examples | Vanguard S&P 500 Index Fund (VFIAX) | SPDR S&P 500 ETF (SPY) |
Example of an Index fund
Index funds have been in existence since the 1970s, but their popularity has surged significantly over the past decade. The pioneering fund, established by Vanguard's chair John Bogle in 1976, remains one of the top performers, distinguished by its impressive long-term performance and minimal cost. The Vanguard 500 Index Fund has diligently mirrored the S&P 500 in both composition and returns. As of March 2024, Vanguard's Admiral Shares (VFIAX) demonstrated an average 10-year annual return of 12.75%, closely tracking the S&P 500's 12.78%—indicating a minimal tracking error. With an expense ratio of 0.04% and a minimum investment requirement of $3,000, it stands as a compelling option for investors.
Here’s a simplified guide on how to start investing in index funds, suitable for both beginners and seasoned investors:
1. Select your investment platform: Begin by choosing an online brokerage or investment platform that suits your needs.
2. Open and fund your account: After selecting a platform, proceed to open an account. This involves providing personal details, setting up login credentials, and completing a questionnaire regarding your investment objectives and risk tolerance. Once done, you'll need to deposit funds, typically via a bank transfer.
3. Choose an index fund: Research various funds to understand their performance history, management fees, and the indexes they track. It's advisable to diversify your portfolio by investing in multiple index funds.
4. Purchase shares: Once your account is funded, you can buy shares of your selected fund. Most platforms offer a user-friendly interface for purchasing shares directly through their website or app, requiring only a few clicks.
5. Monitor and adjust as necessary: While index funds are generally considered long-term investments, it's prudent to periodically review your portfolio to ensure it remains aligned with your financial objectives. Adjustments may be needed based on changes in your circumstances or market conditions.
Are Index funds superior to individual stocks?
Index funds follow collections of numerous stocks or bonds, providing investors with the advantages of diversification, which include enhancing the expected return of the portfolio while mitigating overall risk. While the price of any single stock may experience significant declines, if it represents a relatively minor portion of a broader index, the impact is less severe.
What are the best Index funds for retirement?
The top index funds suited for retirement provide growth opportunities and effective risk management that match your retirement timeline and risk tolerance. For long-term growth, consider broad-market equity index funds such as 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 beneficial. Additionally, target-date retirement funds, which adjust their allocation automatically as retirement nears, offer a convenient option for retirement planning.
Are Index funds good for beginners?
Index funds present an attractive option for newcomers venturing into the investment arena. They offer a straightforward, cost-effective means of holding a diversified portfolio of stocks or bonds that mirror a specific benchmark index. With lower expense ratios compared to most actively managed funds, index funds are not only affordable but frequently outperform them as well. These factors render them a solid choice not only for beginners but also for many seasoned investors. Moreover, a key advantage for novice investors is that if their fund is linked to a major index like the S&P 500 or Nasdaq composite, they will often encounter news coverage related to it, aiding in staying informed about their investment while gaining insights into broader market trends.
What is the appropriate cost for investing in an Index fund?
Index funds typically boast modest annual fees, and these fees have generally been decreasing in recent years. As per the most recent data from the Investment Company Institute in 2024, the average fee for an index fund stands at 0.04%, with certain index funds offering even lower expense ratios. Assuming all other factors are equal, opting for the fund with the lower cost among those equally tracking the same index is advisable.
The Bottom line
Index funds are a favored option for investors seeking inexpensive, diversified, and passive investments, often surpassing many actively traded funds with higher fees. These funds are structured to replicate the performance of financial market indexes, such as the S&P 500, making them suitable for long-term investment strategies like retirement planning. While offering benefits like reduced risk through diversification and consistent long-term returns, index funds are also susceptible to market fluctuations and lack the flexibility of active management. Despite these limitations, they are widely preferred for their dependable performance and have become a staple in numerous investment portfolios. When selecting an index fund, it's essential to consider your investment goals and risk tolerance. Seeking guidance from a financial advisor for tailored recommendations is advisable.
