What is an Index Fund?

Index fund investing got its start in 1976, but in less than 50 years, these funds have grown to represent just over half of all fund investments. It’s clear that both financial experts and individual investors see the virtues of investing in index funds.

What is an index fund, and should you invest in them?

Why Invest in Index Funds?

Part of the reason for the rapid growth in index funds is the many benefits they provide.

Examples include:

1. There are currently 1,437 index funds to choose from.
2. Index funds cover virtually every niche of the stock market, from the general market to specific industry sectors to geographic regions.
3. Index funds are also available for bonds and other asset classes.
4. The funds trade like stocks and can be easily bought and sold — commission-free — through investment brokers.
5. You can invest in index funds with as little as $1 using fractional shares.
6. You don’t need any specific investment knowledge to invest in index funds.
7. It’s possible to build a fully diversified portfolio using just four or five different index funds.
8. Index funds are totally passive, which means your only responsibilities are to choose the funds you want to invest in and then contribute to them on a regular basis.
9. It’s very easy to dollar-cost average with index funds since they are less dependent on events, like earnings reports, than individual stocks.
10. Index funds can form the base of your portfolio, freeing you up to invest smaller amounts in individual stocks to gain investment knowledge and take advantage of special opportunities.

The Tax Advantages of Index Funds 

This is yet another benefit to investing in index funds and one that requires its own discussion.

Because index funds are based on the composition of the underlying index, securities are only traded when there are changes within the index. Since that is a relatively rare event, index funds trade stocks only infrequently. This means they generate little in the way of taxable capital gains. 

Instead, the individual share price of an index fund rises over time. No tax liability is generated until you sell your position in the fund. That creates a type of tax deferral normally available only in tax-sheltered accounts, like retirement accounts. The advantage is even greater if you hold your shares for more than one year since any gains will be taxed at lower long-term capital gains rates.

For that reason, index funds can be an excellent choice in a taxable brokerage account, as well as a retirement account.

An index is a popular measure of either the general investment market or specific slices of it. Respected industry institutions, like Dow Jones & Company, NASDAQ Inc., and various large fund families, create indexes that are utilized throughout the industry.

A popular example is the S&P 500 Index, which was created and is managed by S&P Dow Jones Indices. Launched in 1882, the index tracks the performance of the 500 (or so) largest publicly traded corporations in the United States (by market capitalization). As such, it represents approximately 80% of the value of publicly traded stocks on all exchanges in the US. The index is highly valued because it provides the single largest representation of the overall US stock market.

While the S&P 500 Index is considered a more general index, there are many more that are very specific. For example, there are market indexes attached to the performance of specific industries, such as automobiles, airlines, energy, primary metals, consumer durables, consumer nondurables, and healthcare, just to name a few. There are others that are related to geography. For example, there indexes the track the stock markets in Japan, the European Union, the UK, Latin America, and other countries and regions.

What is an Index Fund?

Investment managers create portfolios designed to track the underlying indexes. This eliminates the need to research individual companies and buy and sell individual securities in an attempt to outperform the market. Instead, the fund manager maintains the portfolio to match the index, so the fund and index’s performance are identical.

For this reason, index funds are commonly referred to as passive funds. This gets to the fact that they require no active management (buying and selling of securities) by either the fund manager or by individual investors.

Both individual and institutional investors can purchase shares in index funds for their portfolios. When index funds are exchange-traded funds (ETFs) — as most index funds are — they trade like individual stocks. They can be bought and sold through investment brokers, usually commission-free.

Common Types of Index Funds

If you’ve heard of a market or industry sector, it’s almost certain there’s an index fund tied to it.

Examples include:

• Large-cap stocks (like the S&P 500)
• Mid-cap stocks
• Small-cap stocks
• Technology stocks
• Healthcare stocks
• Real estate-related stocks
• Gold stocks and bullion
• Energy stocks
• Building materials stocks
• Utility stocks
• International stocks
• Emerging markets stocks
• Government bonds
• Corporate bonds
• International bonds
• Municipal bonds

That’s just a small sampling of the types of index funds that are available.

Some of the most popular index funds include:

• SPDR S&P 500 ETF Trust (SPY)
• Invesco QQQ ETF (QQQ)
• Vanguard Real Estate ETF (VNQ)
• Vanguard Health Care ETF (VHT)
• Vanguard Total International Bond Index Fund Admiral Shares (VTABX)

The above funds are so popular that they are frequently included in professionally managed portfolios, as well as robo-advisor portfolios.

Index Fund Costs

One of the major advantages of index funds is their low cost. Unlike actively managed funds, index funds do not charge load fees. This is important because load fees can be as high as 8.5% but are more typically in the 1% to 3% range. However, they are not a factor when it comes to index funds.

As noted earlier, index funds are commonly available through investment brokers commission-free.

However, there is one cost associated with index funds, and that is expense ratios. Expense ratios are annual fees charged within an index fund to cover various expenses, like marketing and administrative costs. They can be as high as 1% of the value of your fund position each year, but index funds are commonly available with expense ratios under 0.10%.

How to Invest in Index Funds

There are various ways you can invest in index funds. Perhaps the most popular way is through investment brokers like Ally Invest, SoFi Invest, and E*TRADE. You can choose from hundreds of index funds with each broker, and all are available commission-free.

If you prefer, you can also invest directly with the sponsoring fund family. Popular fund families include Vanguard, Fidelity, and iShares. Similar to investment brokers, you can purchase positions in index funds commission-free.

Still, another way to invest in index funds is through robo-advisors. These are online, automated investment services that provide complete portfolio management at a very low fee. Popular robo-advisors include Betterment, Wealthfront, and SoFi Invest.

If you prefer to choose your own index funds, and even mix in a few individual stocks, you should investigate M1 Finance. There, you can select up to 100 individual stocks and exchange-traded funds, which M1 Finance will then manage free of charge. You can even create multiple portfolios with the service.

Pros and Cons

Pros:

• Index funds will not underperform the market index they track.
• Provides a fully diversified portfolio across hundreds or thousands of individual securities.
• Index funds are available for stocks, bonds, and other asset classes.
• There is no need to manage your index fund other than to choose which funds to buy and when.
• Index funds are simple to buy and sell and are available through most brokerage firms with no commissions.
• Since index funds only buy and sell securities when the composition of the underlying index changes, they generate very little in the way of taxable capital gains.
• Since an index fund performs like a stock, its share value can grow over many years, deferring any tax liability until your position in the fund is sold.

Cons:

• An index fund will never outperform the underlying index.
• Because so many index funds are based on market-cap weighting, the performance of the fund may primarily be determined by a small number of very large companies.
• Because they are passive investments, index funds may not provide you with an opportunity to increase your investment skills and experience.
• Index funds can be a bit boring if you like the excitement of trading individual stocks.

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