This content is created by AP Buyline in accordance with AP’s editorial guidelines and supervised and edited by AP staff. Our evaluations and opinions are not influenced by our advertising relationships, but we may earn commissions from our partners’ links in this content. Learn more about AP Buyline here.
In a nutshell
Index funds hold securities according to an index that tracks the securities, like the S&P 500 or the Nasdaq. The securities held in these funds are adjusted based on the index they track in order to keep the performance of the fund in line with that of the index. If you invest in a S&P 500 index fund, for example, the performance of the fund should closely mirror that of the index.
- Index funds are an opportunity to invest in broad markets or specific industry sectors.
- Index funds are considered passive since their performance is not based on trading securities.
- Index funds are low-cost and should represent the foundation of your portfolio.
What is an index fund?
An index fund is a portfolio of stocks specifically designed to match the composition and performance of an underlying index. Indexes, like the S&P 500, Dow Jones Industrial Average and Nasdaq, are created by companies like Dow Jones, S&P Global and Nasdaq Inc. as a means of measuring the performance of the stock market.
Not only will the composition of the index fund match the index, but the fund will not trade any securities unless the index makes changes in its composition. That means buying and selling securities within an index fund is relatively uncommon.
Because of this close tie with indexes, index funds will neither outperform or underperform the underlying index they are matching.
Different types of index funds
As the popularity of index funds has increased in recent years, so have the types of funds offered.
The most common and popular types of index funds are broad market index funds. Those are funds tied to common broad market indexes, like the Dow Jones Industrial Average, the S&P 500 and the NASDAQ. Even broader market participation is possible through funds tied to the Russell 2000 or the Wilshire 5000, which represent a larger number of companies.
Index funds can also be based on the size of companies, as determined by the market capitalization of their stock. An index would be considered a large-cap fund, but there are also funds that invest in companies with smaller capitalizations. They can be mid-cap, small-cap or even micro-cap.
A large number of funds are now based on industry sectors. This can include consumer durables, consumer nondurables, manufacturing, technology, biotechnology, energy and raw materials.
Some funds are based on geography. For example, you can invest in an index fund that’s based on companies in South America, China, Japan, Europe and elsewhere.
There are also index funds that invest in bonds. This will allow you to add bonds to your index fund portfolio, without the need to purchase individual bond issues. A variation on this model is a balanced index fund that includes both stock and bond allocations.
Even more specializations have been developed recently. One popular type are index funds based on socially responsible investing. Such funds invest in indexes of companies considered to emphasize social responsibility in the conduct of their business.
In today’s diverse investment environment, there’s an index fund for virtually every sector you can imagine and more being added all the time.
Benefits of index funds
Built-in diversification
When you invest in an index fund, you are buying into a portfolio that represents stocks issued by all companies covered by that index. For example, an index fund that invests in the S&P 500 includes positions in every stock in that index. There is no need to invest in additional companies for greater exposure.
Simple management
Once you buy into an index fund, you will have no management responsibilities. That means you will not need to research component companies or decide when to buy or sell shares. 100% of the management is provided by the fund itself.
Low cost
Because index funds are tied to an underlying index, there is very little buying and selling of securities within the fund. That enables the fund to be managed with very low fees. By contrast, actively managed funds have higher fees because of the greater volume of trading that takes place within the fund.
In addition, index-based ETFs are widely available commission-free with most brokers.
Lower tax consequences
This once again relates to the passive nature of index funds. Trades take place only when the underlying index changes its composition, which is fairly rare. The scarcity of trades means there are few capital gains distributions that may be taxable, especially at short-term capital gains rates.
Index-based ETFs have shares much like stocks, and the value of your shares increases as the securities within the fund rise. You won’t experience a major taxable capital gains event for as long as you are holding your shares in the fund. This makes investment in these funds a type of tax deferral strategy, even outside a retirement plan.
Disadvantages of index funds
Index funds will perform no better than the underlying index
While index fund investing tends to be less volatile than investing in individual stocks or actively managed funds, they are hardly risk-free. Since the fund is tied to the underlying index, it will rise and fall with that index. In a broad-based bear market, index funds will decline with the rest of the market.
In other words: If you are hoping to outperform the market, index funds are not for you. They’ll never outperform it because they represent the market itself.
Many index funds are heavily reliant on the performance of a few large companies
This refers to a common index fund management strategy known as market-cap weighting. It’s a strategy in which the fund holds positions in stocks within an index based on the total market value of their outstanding shares. This is very different from an index fund that might invest in the S&P 500 with equal positions in all 500 or so component companies.
For example, a market-cap weighted S&P 500 fund will hold proportionately larger positions in companies like Apple, Nvidia, Facebook and Alphabet than other companies in the index. That can skew the performance of the fund, based on the performance of a small handful of companies' stocks.
That strategy tends to work very well during times when the biggest components of the index are performing well. But if some or all of those companies suddenly dive, they’ll pull down the value of the fund, regardless of what is going on with the other 490 stocks within the fund.
How index funds work
Index funds are a unique type of fund that is tied to an underlying index. The index can be based on the S&P 500, the NASDAQ, the Russell 2000 or any number of indexes based on specific industries or geographic sectors. That allows you to invest in broader markets, specific industries or even individual countries or global regions.
The fund is set up to include positions in all the component companies within the index, frequently based on the market capitalization of the companies within it. Those with greater market capitalization will have larger allocations and companies with smaller market capitalizations will make up a smaller share of the fund.
Index funds are considered to be passive funds specifically because they are tied to an underlying index. This is unlike actively managed funds, which attempt to outperform market indexes by regularly buying and selling shares within their funds. As a result, index funds are lower cost than actively managed funds.
When you invest in index funds, it’s important to understand from the outset that the fund will neither outperform or underperform. It will rise and fall with the index.
How to invest in index funds
The most common way to invest in index funds is through investment brokers that offer them. For example, TradeStation offers investors access to thousands of index funds, all commission-free. They also offer commission-free trading of stocks and options, though options do have a $0.60 per contract fee. Other investments on the platform include futures, futures options and mutual funds.
Similarly, Robinhood has commission-free trading in ETFs — including index funds — as well as stocks. Robinhood also offers trading in options and cryptocurrencies. If you plan to have an IRA account, it also offers to match your contribution by as much as 3%. That’s free money, on a platform that charges no commissions for index fund investing.
How to select index funds
The process starts by deciding which index funds you want to invest in. If you’re looking to invest in the general market, a fund based on the S&P 500 index is very popular. You may also want to supplement that with some sector funds if you believe certain industries are likely to outperform the S&P 500. You may decide to choose index funds based on industries like biotechnology, healthcare or energy. You can also add a bond index fund for diversification purposes.
When comparing index funds, pay careful attention to the expense ratio of each. There can be considerable variation here, and you’ll want to lean toward those with the lowest fees.
Next, you’ll need to choose the investment broker where you will buy and hold the funds. Many brokers will allow you to open an account with no funds at all, but you will need money in the account to invest. That’s when you’ll need to decide exactly how much you want to invest upfront.
You can make a large investment all at once, but most investment advisors recommend dollar cost averaging. Much like making regular payroll contributions into a retirement plan, you will set your fund allocations in your account and then add a fixed amount to the account regularly. This can often be done by setting up a direct deposit from your salary directly into the brokerage account.
Once you have your portfolio in place, and you are adding to it regularly, you’ll need to periodically rebalance your account.
Over time, the value of some funds will outperform others. If you set percentage allocations, you can rebalance your portfolio each time one or more funds move well beyond your target allocations. That’s a simple process of selling shares in one fund and moving the money into a lower-performing fund.
How big is the difference between index funds and actively-managed funds?
The difference is surprisingly small, which makes actively managed funds even less desirable since they involve greater risk. According to Morningstar, only 47% of actively managed funds match or exceed the performance of index funds. That means index funds outperform actively managed funds 53% of the time.
While actively managed funds sometimes outperform index funds by a wide margin in a single year or two, they are at least equally prone to seriously underperform them. From a long-term investment perspective, slow and steady is usually preferred to dramatic swings in both directions.
How much do index funds cost?
Index funds can be traded commission-free with many popular investment brokers; however, they do have annual fees, known as expense ratios. These are fees charged each year by the management of the index fund for costs such as marketing, administration and management.
The average expense ratio for index ETFs is 0.54% per year, but 0.87% for index mutual funds. Many index ETFs are available with much lower fees. For example, the very popular Vanguard S&P 500 ETF (VOO) has an expense ratio of just 0.03%.
When researching which index funds to invest in, pay careful attention to the expense ratio. A fund with an expense ratio of 0.10% will result in an annual return that’s 0.40% higher than a fund with an expense ratio of 0.50%. That will have a big impact on the performance of the fund over the long term.
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If you’re like most investors, index funds will likely prove to be the best overall strategy for your portfolio. Not only are they less volatile than individual stocks, but they require a lot less work. Since the fund represents a ready-made and managed portfolio, there is no need on your part to choose stocks, manage the portfolio and decide when to buy and sell securities. You can simply set allocations in several index funds, then steadily add funds to your portfolio according to the fund allocation you have set.
Frequently asked questions (FAQs)
What is the typical return on index funds?
There’s no standard answer to this question. That’s because there are many different index funds, representing different market segments and industry sectors. Historically, the average annual return on the S&P 500 has been around 10%. However, that’s an average. You can expect significant fluctuations from one year to the next. One year the index may be up by 25%, and the next year it may be down by 30%.
Average returns are even less certain with sector funds since any particular sector can go into a long-term bull market or a long-term decline. Most funds publish returns going back up to 10 years, but there will be fluctuations even within a single decade.
Is investing in an index fund a good idea?
Financial advisors consider index fund investing to be a reliable foundation in just about any portfolio. This is especially true for new and small investors or those who lack the time and inclination to engage in active do-it-yourself investing.
The advantage of an index fund is that you don’t need to attempt to time or outguess the market. You can simply invest in the fund, and its performance will match that of the underlying market. You will never do better than the market, but you won’t do worse.
How much money do you need for an index fund?
The minimum investment is determined by the investment broker, at least in the case of index-based ETFs. Since they trade like stocks, ETFs can be purchased for the cost of a single share of the fund. But if the broker permits fractional investing, which is buying small slices or fractions of shares, you can buy into a fund for as little as $1.
With index-based mutual funds, the situation may be different. Mutual funds usually set a minimum investment, which can be $1,000 or more. You’ll need to invest whatever the minimum established by the fund is.
Are index funds better than stocks?
For most investors, index funds are the better choice. Not only are the funds less volatile than individual stocks, but they tend to provide more stable returns over the long term. Very few individuals — or even actively managed funds — can outperform index funds over many years.
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This content is created by AP Buyline in accordance with AP’s editorial guidelines and supervised and edited by AP staff. Our evaluations and opinions are not influenced by our advertising relationships, but we may earn commissions from our partners’ links in this content. Learn more about AP Buyline here.
