You don’t have to be a pro to build wealth in the stock market. In fact, index funds are a popular asset class that takes much of the work involved in investing off the table.
Perhaps that’s why Warren Buffett believes they’re the perfect investment for most investors.
These funds provide low-cost, diversified access to gains without significant research requirements or market experience. But what exactly is an index fund, and are they really as great as Buffett says they are?
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of an underlying benchmark index.
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These funds collect investments from a large group of investors and use their investment dollars according to the fund’s prospectus. This document outlines the fund’s objectives, the market index that the index fund tracks, and how the fund manager plans to achieve the fund’s investment objectives.
Index fund investors share in price appreciation and dividends generated from the fund’s investments based on the number of shares they own.
For example, one of the most popular index funds on the market is the Vanguard Total Stock Market Index Fund. The fund tracks the CRSP U.S. Total Market Index, achieving results by purchasing shares in stocks listed on the index. Vanguard investors who own shares of the fund experience gains when the benchmark is trending up and declines when it’s trending down.
Moreover, when stocks listed on the benchmark index pay dividends, those dividends are split up and paid to the fund’s investors based on the number of shares they own.
How Index Funds Work
Index funds are very similar to other types of mutual funds and ETFs. They all accept investments from a large group of inventors, invest according to the details of their prospectuses, and share gains and dividends with investors.
The difference is how the funds are managed.
Index funds are passive investments, so the fund manager doesn’t use a range of aggressive strategies in an attempt to beat the market. There’s no need for a team of traders and analysts who find and make moves in the market. Instead, fund managers only make moves when the underlying indexes do.
After all, the goal of an index fund is to closely mirror the results of the underlying index it’s centered around. This is generally done by investing in each stock listed on the index with the same weighting the index uses.
The lack of legwork required for the fund manager is a big advantage for the investor too. Index funds have significantly lower expense ratios than their actively managed counterparts. When you invest in index funds, you get to hold onto more of your gains.
What Indexes Do Index Funds Track?
The popularity of index funds has led fund managers to create funds that track just about any benchmark index you can think of.
The most popular benchmark is the S&P 500. The S&P 500 is made up of the 500 largest U.S. stocks by market capitalization and is largely regarded as the flagship benchmark for the U.S. stock market.
Other popular benchmark indexes for index funds include:
- Bloomberg U.S. Aggregate Bond Index. The Bloomberg U.S. Aggregate Bond Index is one of the most popular benchmarks for bond index funds. The index is designed to track the performance of U.S. dollar-denominated investment-grade taxable bonds.
- Dow Jones Industrial Average. The Dow Jones Industrial Average (DJI) is a large-cap index made up of 30 of the largest, most prominent U.S. companies. DJIA funds attract investors who are interested in investing in market leaders that pay dividends.
- Nasdaq Composite Index. The Nasdaq Composite index is a highly diversified list of stocks across all sectors. However, the majority of stocks listed on the index are in the tech, biotechnology, and healthcare sectors. As a result, Nasdaq-centric index funds often attract tech and growth investors.
- MSCI EAFE Index. The MSCI EAFE Index is a diversified group of stocks from Europe, Australasia, and the Far East. This index is popular with investors interested in international exposure.
- Russell 2000 Index. The Russell 2000 Index is one of the most diversified groups of small-cap stocks available, so funds that track the index are attractive for investors who want to expand their gains by getting in on the ground floor with their investments.
- Wilshire 5000 Total Market Index. The Wilshire 5000 Total Market Index is one of the most inclusive representations of the large-cap corner of the U.S. stock market. In fact, the benchmark represents more than 80% of the entire United States market cap.
Pros & Cons of Index Funds
Index funds are solid investment options for the right inventors, but they’re not perfect. There are a few pros and cons to consider before getting involved in them. Here are the most significant:
Pros of Index Funds (They’re Great for Passive Investors)
Index funds have become a popular investment vehicle by offering investors several perks. Some of the biggest advantages to investing in these funds include:
- Heavy Diversification. Most index funds are highly diversified groups of stocks. This high level of diversification provides some protection from volatility. When an individual stock or even a small group of stocks in the portfolio takes a dive, gains in other holdings may offset the blow.
- Low-Cost Investing. Index funds are known for low fees. Not only can they get away with lower expense ratios than actively managed funds, but a single investment often represents ownership in hundreds or even thousands of stocks. That cuts down on trading fees.
- Passive Investing. You don’t have to worry about spending hours researching individual stocks when you invest in these funds. Index investing is largely passive, though you should still compare each fund that provides access to a particular index. They’re not all created equally.
- Lower Taxes. Index funds generally hold investments for the long term. They make very few trades that could trigger tax events, so you benefit from lower capital gains taxes when reporting your investment income. There are also other beneficial tax loopholes associated with ETFs.
- Reasonable Returns. Index funds track the performance of the overall market or specific sectors. While not designed to beat the underlying benchmarks, they provide reasonable returns in line with those benchmarks.
Cons of Index Funds
Index funds might seem like the best thing since sliced bread. But even sliced bread has its flaws, and these investments are no different. The biggest drawbacks to investing in index funds include:
- No Chance to Beat the Market. Index funds are highly diversified investments that produce reasonable returns. Just remember that you’re not going to beat the market if you are the market. Index funds’ high level of diversification limits losses but can also limit gains.
- Lack of Control. When you invest in an index fund, you hand control over your investment to the fund manager. The fund manager won’t only be charged with choosing your investments for you, they’ll also vote on your behalf when propositions make their way to shareholder votes. For example, a company considering an acquisition offer will usually hold a shareholder vote to make sure the majority of holders agree with the move.
Is an Index Fund Right for You?
Index funds are great investments for the right investor. So, how do you know if you’re the right investor? Consider your market knowledge, investment objectives, and desire to control your portfolio.
These funds may be the right investment vehicle for you if:
- You’re a Beginner. You can be successful as an index investor with very little market research or experience. This makes index funds the perfect investment vehicle for the beginner investor.
- You’re Busy. Even if you have plenty of market experience, you might not have the time it takes to manage a diversified portfolio of individual stocks. Index funds can be a useful substitute.
- You’re Investing for Retirement. Index funds often comprise the core holdings in 401(k) and IRA portfolios thanks to their long-term time horizon and heavy diversification.
- You’re Risk Averse. If you’re a risk-averse investor, index funds’ heavy diversification will put your mind at ease.
- You Enjoy the Slow & Steady Approach. You won’t get rich quickly investing in index funds, but you will build wealth over time. So, if you’re interested in a slow and steady approach to investing, these funds may be the perfect fit.
How to Invest in Index Funds
Although there’s less work involved in index investing than there is in picking individual stocks, there are still a few steps that you should take to ensure success.
Step #1: Decide which Type of Fund You’re Interested In
Are you interested in growth, income, or value? Would you rather invest in domestic stocks, international stocks, or a mix of the two? It’s important to know what you want to invest in before looking for an investment.
Step #2: Make a Spreadsheet
Use the following titles on the tops of the columns on the spreadsheet: Fund Name, 5-Year Performance, Dividend Yield, Expense Ratio.
Step #3: Fill out the Form
Now, search Google or Yahoo! Finance for funds in the category you’re interested in. For example, if you want income, search “Income Funds.” Use the results to fill out the spreadsheet. Include at least 10 different funds.
Step #4: Compare Your Options
The ultimate goal is to invest in funds that have the strongest historic performance and charge lower fees than their competitors. Use the data in your spreadsheet to find your best options.
Step #5: Make Your Investments
Finally, log into your brokerage account and buy shares of the funds that charge the lowest management fees and produce the best investment outcomes.
Index Fund FAQs
It’s important to ask questions before you invest in anything, including index funds. These are some of the most common questions that come up for would-be index fund investors.
What’s the Difference Between an Index Fund vs. Mutual Fund?
An index fund can be a type of mutual fund or ETF, but mutual funds aren’t always index funds.
There are two types of mutual funds on the market. Those are index mutual funds and actively managed mutual funds.
Index funds take a passive management approach, investing in an attempt to produce returns equal to those generated by the underlying benchmark. Active mutual funds take an active approach to investing, deploying complex strategies in an attempt to beat the returns of their underlying benchmarks.
What Are Index Exchange-Traded Funds (ETFs)?
Index ETFs are index funds that are traded on public stock exchanges like the Nasdaq or New York Stock Exchange (NYSE).
These funds differ from index mutual funds that trade once per day at the close of the market. Instead, they trade freely throughout the trading session on a public exchange.
How Can You Buy Index Funds?
The easiest way to buy an index fund is to purchase shares through your brokerage account. Keep in mind that not all brokers offer access to index mutual funds. If the funds you’re interested in are mutual funds, you may have to make your investment directly through the fund provider.
What Is Indexing?
Indexing is an investment strategy centered around index investing. By building a portfolio of multiple index funds, you tap into various types of stocks and benefit from the risk protection offered by heavy diversification.
Some of the most popular indexing portfolios include the Scott Burns Margarita Portfolio, the Talmud Portfolio, and the Warren Buffett ETF Portfolio.
Do All Index Funds Produce Similar Results?
Different index funds produce different returns. That’s because they’re each managed by different fund managers and track different market indexes. For example, an S&P 500 market index fund will perform differently than a mid-cap index fund.
Moreover, two funds that focus on the same market capitalization and market index may perform differently depending on how they’re managed. For example, a Fidelity index fund might have different performance metrics when compared to a similar index fund managed by Vanguard.
Which Companies Provide the Best Index Funds?
There are several fund management companies to choose from. Some of the most popular include Vanguard, Fidelity, and Charles Schwab.
Final Word
Index funds are the perfect investment vehicle for most investors, as alluded to by Warren Buffett. However, they’re not for everyone. If you’re a beginner or busy investor who’s OK with relinquishing control and taking the slow and steady approach to investing, indexing may be the way to go.
However, if you have plenty of market experience and time to do the research, you might want to consider building a portfolio of individual stocks. That’s especially the case if you’re interested in taking risks to beat the market over the long term.
