What Are Index Funds, and What Are Their Benefits?

What Are Index Funds? Should You Invest in Them?

One investment option that new and experienced investors both hold are index funds. Many investors consider index funds to be the most efficient way to earn passive income. And, investing in index funds requires minimal skill and time.

Whether you’re busy in your career or have minimal interest in investing, index funds make it easy to invest.

You can use index funds to invest for retirement. Or, to build wealth in your taxable account too.

In a world where most of us don’t have pension funds to rely on in retirement, investing is essential if you want to build a large nest egg. Index funds help the common person invest and build long-term wealth.

Before you invest in just any index fund, you need to know what they’re all about first. With any investment, you need to know the answer to these two questions:

• How does the investment make money?
• What are the potential risks and rewards?

The answer is different for each investment. For example, Apple makes money by selling phones, tech devices, and streaming music and video. But, their stock price might drop when they don’t meet sales expectations or a competitor (i.e. Samsung) launches a new phone.

Index funds are one of the simplest investments to understand. They invest in the broad market.

With a single investment, you invest in every industry for companies of a similar size. So, you can invest in Apple and Samsung, plus many other companies at the same time.

Basically, when the index goes up, you gain money. But, your portfolio loses value when the index goes down.

Since most index funds hold small positions in hundreds of companies, your investment performance doesn’t rely almost completely on one or two companies.

You’re not going to have the volatility that comes with only investing in a few stocks.

What Are Index Funds?

Index funds are a basket of individual stocks that track the performance of a specific stock index. For example, an S&P 500 index fund holds positions in the 500 companies that form the S&P 500 index.

Since index funds are passive funds, they only try to track the benchmark index performance.

So, if the S&P 500 gains 2% in a day, the index fund will have similar performance. On the downside, it declines the same amount on down market days too.

As index funds only try to track market performance, they also have lower management fees. This is because they don’t buy and sell stocks as often as actively managed funds that try to outperform the market.

The average annual expense ratio for index funds is about 0.09%. For every $1,000 you invest, the fund manager keeps $0.90 a year.

With an active fund, the expense ratio might be 1% or higher. In this case, the fund manager keeps $10 in fund fees each year. This means the active fund must earn $10 more each year to make up the difference.

Some of the potential indices you can track include:

• S&P 500
• Russell 2000
• Nasdaq
• Dow Jones Industrial Average
• Developed International Markets
• Emerging Markets
• FTSE (100 largest companies on the London Stock Exchange)
• Real Estate Investment Trusts
• Corporate and Government Bonds

To diversify your portfolio, it’s a good idea to buy index funds that track different benchmarks. For example, don’t put all your money in the S&P 500.

While the S&P 500 has been one of the best performing markets long-term, other indices might have better performance. Investing in U.S. small cap companies and international markets, you can earn more income in certain years. And, just because one index has a bad year doesn’t mean the others will too.

This way, you gain exposure to each market sector. And, you minimize your downside risk in the process. With any investment, you must consider how much money you can lose in a market downturn.

Index Funds vs. Active Funds

The opposite of a passive index fund is an active mutual fund. With active funds, the fund manager invests in companies that he believes will perform better than the index.

In this market cycle, companies like Google, Facebook, Amazon, and Netflix (the so called FANG stocks) have performed significantly better than the broad market. So, the fund manager might own more of these stocks and avoid lagging stocks like General Electric.

As you can see in the screenshot below, you can see the 10-year performance results for these three investment options:

• S&P 500 Index
• S&P 500 Index Fund (Ticker Symbol: SWPPX)
• Morningstar Large Blend Fund Category

The large blend category is 794 similar funds that invest in the largest publicly-traded companies. This category includes passive index funds and active mutual funds.

As you can see, the performance of the SWPPX index fund is slightly less than the S&P 500 index. The main reason why the index funds lags the market is the small fund fee.

Compared to actively managed funds, index funds outperformed its large blend category. While some active funds picked the right stocks to beat the index, most fell short.

By investing $10,000 in an S&P 500 index fund from October 15, 2008 to October 15, 2018, you made $4,000 more than investing in the average large cap mutual fund.

Difference Between Index Funds and Index ETFs

For decades, index mutual funds were the only way to invest in passive funds. This is still the case with your 401k. But, a more affordable option for your IRA or taxable brokerage account is buying the index ETF.

Although index mutual fund operating costs are low, ETF fund fees are usually lower. And, you only need enough money to buy a single share to invest.

Some brokerages might require a minimum $3,000 initial investment for a mutual fund. Or, you can buy the ETF equivalent for $143 a share. When you only have $1,000 to invest, the ETF is the better option to start investing.

One other large difference between index funds and ETFs is that mutual funds only trade when the market closes. With an ETF, you can buy or sell shares on-demand.

If the market closes higher than the opening price, you might be able to buy the same shares for less money. But, for most investors, trying to time the market isn’t worth the effort.

What’s more important is consistently investing so you can gain exposure to the broad market.

Leading Index Funds

Most brokerages have their own index fund. While there are slight differences between the position sizes of each index fund, the fund performance is virtually identical.

Fidelity and Vanguard offer some of the largest selections of index funds. With your current broker, choose the index fund with the lowest expense ratio. This way, you have the highest income potential.

Below is a brief list of some of the most popular index funds by three brokers. You might look for these in your 401k plan. Or, you can always choose the ETF version if you prefer ETFs more.

Fidelity

Fidelity offers several “ZERO” index funds that don’t charge fund expenses. This means you keep 100% of your annual earnings!

Vanguard

Vanguard receives the most credit for making index funds the popular investing option they are today. Many of their index mutual funds have a minimum $3,000 initial investment. If you can’t make a minimum, consider getting the ETF equivalent instead. And, your fund fees are lower too.

Charles Schwab

Most of Schwab’s index funds have a minimum $100 initial investment. After establishing a position, you only need to invest $1 each time to buy future shares.

Pros

These are the reasons to invest in index funds:

• Instant exposure to an entire index
• Matches performance of the index the fund tracks
• Most cost-effective way to invest in multiple companies
• Lowest fund fees
• Zero time or skill required to invest

The main reason index funds are so popular is they require minimum effort to invest. Most people don’t invest because they think investing requires lots of time and skills to read annual reports and earning statements of single companies.

With index funds, that’s not the case as the professional investors do all the hard work. You only have to decide which index funds to invest in and how much money to invest each month.

If you still don’t want to take the time to choose which index funds to invest, you can also use an investing app like Betterment. They invest in a wide array of stock and bond index ETFs based on your age and investing goals.

Cons

No investment is perfect. These are some reasons why you might not rely entirely on index funds:

• You will never outperform the market
• When the index drops in value, you “lose” money too
• Can’t handpick which companies to invest in

Alternatives to Index Funds

If you have yet to make your first investment, index funds are the easiest way to build a diversified portfolio. Many investors only invest in index funds that track a broad index for their entire investing career.

Owning small positions in many companies reduces your portfolio risk, but you may decide to invest in these index fund alternatives to further diversify your portfolio. Or, you might try and outperform the market with a small portion of your portfolio.

For example, you might decide to keep 90% of your portfolio in index funds. And, the other 10% can be invested in these alternatives.

Target Date Funds

With target-date funds, you pick the fund that’s closest to your planned retirement date.

As you near retirement, these funds gradually shift from a stock-heavy to bond-heavy portfolio. Target date funds usually hold several stock and bond index funds.

In theory, all target date funds should have similar returns just like index funds. But, each brokerage weights different index funds differently. And, some target-date funds are better than others. If you happen to invest in a lagging fund, you may not have enough money to retire.

Sector ETFs

You can also invest in sector-specific funds. For example, you invest in:

• Cybersecurity
• Banks
• Airlines
• Health Care

Instead of owning individual shares of each company, you can own partial shares with each fund. Because most of these funds are actively managed, the fund fees will be notably higher than index funds.

Individual Stocks

The most lucrative yet riskiest option is buying individual stocks. For example, if you purchased shares of Amazon in October 2008, you would pay roughly $48 per share.

Ten years later, those same shares are worth about $1,700. That’s a 3,441% return. Your $10,000 investment would be worth $344,000. Investing the same amount in an S&P 500 index fund only yields $30,767.

The only problem is that you have to pick the right stocks to earn outsize returns. If you invest in individual stocks, you might pick blue chip stocks that pay steady dividends. And, make sure no single stock position exceeds 5% of your total portfolio size.

If you have $50,000 in the market, a single stock position shouldn’t be larger than $2,500. This rule helps ensure your portfolio doesn’t become too risky.

Summary

Index funds are simple to understand. When the market goes up, they increase in value. And, they decrease in value when the market closes lower. Index funds are the easiest option to invest in the market and build a diversified portfolio.