An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to replicate the performance of a specific market index, such as the S&P 500 or the FTSE 100. It is designed to provide broad market exposure and diversification by investing in the same securities that constitute the underlying index.
Understanding an Index Fund
Deciding which stocks to invest in can be difficult, as there are many options. This is one of the reasons why mutual funds and exchange-traded funds (also known as ETFs) were created – they take a bunch of money from individual investors, put it into one big pot, and the fund manager uses that money to invest in different areas. In this way, an investment fund share is like a cocktail: a mixture of different investments that an investor can easily buy.
Index funds are like cocktails, with the ingredients carefully measured to mimic the well-known stock market indices. The result is an inexpensive way to diversify your investments. If you want to invest in stocks but don’t know which stocks to invest in, an index fund may be an investment you may want to consider.
How does an Index Fund work?
An index fund operates by passively replicating the performance of a specific market index. The fund manager selects an index, such as the S&P 500, and constructs a portfolio that closely mimics the index’s composition and weighting. The fund invests in the same securities that comprise the index, aiming to achieve similar returns.
The fund’s holdings are typically diversified across a wide range of securities, reducing the impact of individual stock performance. This diversification helps to mitigate risk.
The fund’s portfolio is structured to match the index’s proportions, meaning that if a particular stock represents 2% of the index’s value, the fund will allocate approximately 2% of its assets to that stock. The fund manager periodically rebalances the portfolio to maintain alignment with the index. Rebalancing involves adjusting the fund’s holdings to reflect any changes in the index’s composition.
The fund distributes dividends to its investors based on the dividend payments received from the underlying securities. Similarly, any interest or income generated by the fund’s holdings is typically passed on to the investors. The fund’s performance closely tracks the performance of the index it replicates. If the index rises, the fund’s value generally increases, and if the index declines, the fund’s value tends to decrease.
Investors in an index fund become partial owners of all the securities held within the fund. Their returns are directly linked to the overall performance of the underlying index.
Popular index funds
There is a stock index, which is calculated to track the movement of many different segments of stocks. There are stock indices for whole countries, whole sectors. There are even indices for bonds. And for every popular market index, there is likely to be a mutual fund or ETF set up to track it.
Here are some of the most popular stock market indices that have index funds available for investors to buy and sell:
S&P 500: the 500 largest US public companies.
Russell 2000: 2000 small and medium-sized American companies.
Dow Jones Industrial Average: stocks of the 30 blue-chip US companies.
FTSE 100: Britain’s 100 largest companies.
Shanghai Composite Index: an index of all stocks on the Shanghai Stock Exchange.
DAX: Germany’s top 30 large-cap stocks.
This list has no end in sight. If there is a particular country or a particular sector you are interested in, there may be an index fund that tracks the stock market index for it.
Index funds can take the form of either an exchange-traded fund (ETF) or a mutual fund. For example, there are both mutual funds and ETFs that seek to mimic the S&P 500 index.
Expenditures of index funds
Costs are key for index funds – especially the fact that they tend to be lower than other types of funds because they typically require less management than a more actively managed fund. While an index fund does not necessarily have a huge team of researchers and analysts behind it, there are still some administrative, trading and other costs deducted from investor returns.
Some key things to keep in mind
Minimum accounts and investments: Some index funds have a minimum amount required to invest (e.g. $2,000). These minimums may also have thresholds that you cross, allowing you to invest more by adding smaller increments.
Expense ratios: These are the main expenses that are deducted from your income from the fund as a percentage of your total investment. This includes payments to the fund manager, fees, taxes and other administrative costs. The more actively the fund is managed, the higher the expense ratio is likely to be, since the fund manager invests more in research and analysis and wants to be compensated for it. The expense ratio is probably lower for an index fund. It is important to understand the expense ratio before making an investment, because it may undermine the underlying profitability of the fund.
Index funds can exist as both ETFs and mutual funds. The key difference between the two tends to be cost – mutual funds tend to have higher expense ratios than ETFs.
Be aware that not all index funds have lower costs than actively managed funds. Always make sure you understand the actual cost of any fund before investing.
Advantages of Index Funds
Low cost: Funds offer investors the opportunity to invest in tens, hundreds or thousands of shares in a single purchase. For this privilege, fund managers charge investors a fee. A closely watched measure of fees is the expense ratio – a 1% expense ratio means that the fund will take 1% of your investment as its own commission. Index funds have some of the lowest fees of any investment fund available.
Diversification: don’t put all your eggs in one basket. The same advice usually applies to investing. Research has also shown that an equity portfolio that includes stocks that do not change in sync with each other is likely to perform better overall than a portfolio of similar stocks. Index funds can offer good diversification if the underlying index they track is also diverse. Keep in mind that while diversification can help spread risk, it does not guarantee profits or protect against losses in a falling market.
Disadvantages of Index Funds
Lack of flexibility: an index fund may have less flexibility than a non-index fund to react to a decline in the prices of securities in the index.
Tracking error: An index fund may not fully track its index. For example, a fund may only invest in a sample of securities included in a market index, in which case the fund’s performance may be less likely to match the index.
Underperformance: an index fund can underperform its index due to commissions and costs, trading costs and tracking errors.
History of index funds
John Bogle, founder of Vanguard, is known for reminding investors:
“Don’t look for a needle in a haystack. Just buy the haystack!”
What he means is that picking stocks is difficult (find the needle in the haystack), but you are guaranteed to pick the best stocks if you buy the whole stock market.
Bogle was a strong advocate of low-cost mutual funds and passive investing. He created one of the first index funds for individual investors in 1976. Famous investor Warren Buffett also believes that rank-and-file investors should buy the S&P 500 index fund instead of picking individual stocks, because the fees are low and it offers good diversification.
It is important to know what commission an index fund charges when deciding whether or not to invest. Keep in mind that managers usually charge a fee even if the index fund loses money. Further information on the index fund’s fees and costs can be found in a legal document called a prospectus. The prospectus also contains detailed information about the index fund’s investment objective, key investment strategies, risks and historical performance (if any). You can obtain the fund prospectus by contacting the mutual fund or the financial professional selling the fund. Read the prospectus carefully before investing – it contains important information about what you are going to invest your money in.