Low-cost, low-risk, simple and effective â€” index funds check most of the boxes people want in their investment tools. Theyâ€™re also widely hailed by experts as an average investorâ€™s best bet to reach their long-term investment goals. But what exactly is an index fund, and more importantly, is it right for your portfolio?
At the most basic level, an index is a measurement of how well a related group of stocks or other assets are performing â€” a thermometer of sorts. Before we dive too far into index funds, itâ€™s first important to understand what an index is.
Indices may include just a handful of stocks or other assets, or they may include hundreds or thousands of them. The performance of the companies or commodities within each index are factored together to gauge the performance of the overall group.
There are thousands of market indices. Some of the largest stock indices include:
Indices arenâ€™t just for stocks, however. They exist for an array of different asset classes and segments of the economy. They serve as indicators of how a related group of assets â€” like large- or small-cap stocks, or a group of companies in the same industry â€” are performing. Some of the largest non-stock indices include the Chicago Board Options Exchangeâ€™s (CBOE) Volatility Index, the Consumer Price Index (CPI) and the Producer Price Index (PPI).
Market indices are established by financial firms and government regulators, but you canâ€™t invest in indices directly. You can, however, invest in index funds.
Index funds are made up of stocks and bonds that replicate the makeup of an underlying index. The goal is always to match the performance of the underlying index as closely as possible.
Some index funds invest in all of the stocks or other assets that comprise the underlying index, while others are more selective and only invest in a portion of the assets that make up the index. For instance, the component stocks in an index may be weighted, meaning the performance of the entire index is impacted more heavily by the performance of a chosen subset of companies within the index.
For investors, investing in index funds means that instead of picking and choosing each individual stock to invest in, theyâ€™re investing in a predetermined group of stocks. This delivers that key component often thought to be so essential to successful investing â€” diversification. Your profits and losses are measured by how the collective group of companies within the fund does rather than just on how one stock performs. In other words, your proverbial eggs arenâ€™t all in one basket.
Index funds are a passive form of investing. Since the investments are predetermined by the indices, not only do you not have to individually choose the stocks, actively follow them and make decisions about when to buy or sell them, but an advisor doesnâ€™t have to either. Therefore, the fees you must pay to an advisor are typically lower.
Another bonus: Since index funds are meant to be held for long periods of time rather than to be bought and sold as the market fluctuates, investors often benefit from some tax advantages, such as avoiding short-term capital gains taxes. Less money spent on fees and taxes means more money to invest and accumulate interest.
An index fund is actually a type of mutual fund. Mutual funds are financial vehicles that pool investorsâ€™ money and invest it in groups of stocks, bonds and other assets within certain segments. For example, some mutual funds may invest in foreign stocks, while others invest in domestic stocks.
Passive management: What sets index funds apart from mutual funds is that theyâ€™re invested to match the performance of one of the market indices. While most mutual funds are actively managed by a professional fund manager who decides how to allocate the investments and when to buy and sell them, index funds are a subset of mutual funds that are passively rather than actively managed.
Less work â€” and lower fees: The work to set up and maintain your investments in an index fund is quite simple and doesnâ€™t require the same amount of research and work that other mutual funds do. Once you invest, thereâ€™s no worry about following the markets and trying to gauge when to buy and sell. Index funds are meant for long-term growth, and you can simply â€śset and forgetâ€ť them until you need the funds down the road. Therefore, the fees associated with them are typically much lower.
Likely lower returns: Will index funds see the same huge returns that some (rare) individual stock investments do? Probably not, but, in general, theyâ€™re less risky than actively managed accounts that try to beat the market. Typically, they perform better, too. According to the December 2019 S&P Indices vs. Active funds scorecard, over a five-year period, the S&P 500 index did better than 80.6% of actively managed stock funds.
Perhaps the most challenging part about index fund investing is picking the one(s) in which you want to invest. As we said, there are literally thousands of index funds from which to choose. A financial advisor can help you narrow down your choices, but in general, you want to look at the following three factors when choosing an index fund:
Here are some of the top index funds you may want to consider:
The Vanguard S&P 500 Index fund is the oldest index fund for individual investors. It includes 500 of the largest companies in the United States in various industries (those in the S&P 500). The Admiral Shares fund requires a minimum $3,000 investment and has an expense ratio of 0.04%.
The Schwab S&P 500 Index Fund was founded in 1997. As its name implies, it also follows the S&P 500. There is no minimum deposit required, and the expense ratio is 0.02%.
The Barclays Capital U.S. Aggregate Bond Index follows bonds, and there are a variety of funds that follow it, including the iShares U.S. Aggregate Bond Index Fund, which is one of the most prominent. Its expense ratio is 0.04%, and the minimum investment is $1,000 with a few exceptions.
The Invesco DB Commodity Index Tracking Fund invests in the commodities included in the DBIQ Optimum Yield Diversified Commodity Index Excess Return. The index is made up of 14 heavily traded commodities, including heating oil, gold, silver, corn, wheat and sugar. The expense ratio is 0.89%, and while there is no minimum investment listed, they do warn that there may be substantial risk investing in it as futures contracts are volatile.