What are Index Funds?
Some investors take the “if you can't beat them, join them” approach and use index funds to simply track market indices. Funds that track a market index, such as the S&P 500 are known as index funds.
Key Takeaways
These funds typically use a passive investing strategy.
Index funds usually deliver returns that are slightly lower than an index due to fees associated with these funds.
Index funds are built to have a similar performance to that of a major market index.
In this article, we'll discuss how index funds work, identify some of the indices these funds track, and examined benefits and risks associated with this type of fund.
Simply put, index funds are built to have a similar performance to that of a major market index.
This means they tend to be diversified in securities across that index and include a number of investments. There are many market indices and index funds that follow them. For example, if you want to invest in US stocks, you might invest in a fund that tracks an index like:
The S&P 500, which follows the 500 largest stocks in the market.
The Dow Jones Industrial Average which includes 30, large cap industrial stocks.
NASDAQ 100, which follows 100 large cap technology stocks are the
Russell 2000, which tracks 2000 small cap stocks.
For international stocks, an example of a widely tracked index is:
The MSCI EAFE, which includes large cap stocks in developed countries across Europe, Australia and the Far East.
For US bonds an example of a widely tracked index is:
The Barclays Capital aggregate Bond Index, which includes a mix of government bonds, mortgage backed securities, and corporate bonds with different maturities.
Index funds can track different assets, including stocks and bonds. There are even index funds that follow commodities, currencies and other assets.
Regardless of which type of asset they track, an index fund still has its risks.
Put simply, index funds are exposed to the same risks as the index they're following. For instance, if the S&P 500 declines in value, then the index funds that track it will follow suit. An index fund that tracks bonds is at risk if interest rates rise and bonds decline in value. Some investors are willing to accept these risks and choose to invest in index funds because of the potential benefits they might offer.
A primary benefit is the typically lower expense ratio (which is the ongoing cost of investing in the fund compared to an actively managed funds).
As the name implies, actively managed funds use an active investing strategy. This means that they frequently buy and sell investments. This typically results in higher costs or expense ratios and can be a drag on a portfolio's performance over time. Because index funds are passively managed and simply track an index, they generally have a low portfolio turnover, which means they infrequently buy and sell investments. Infrequent buying and selling typically translates into low expense ratios. The low expense ratios of index funds can possibly lead to more growth when compared to the higher expense ratios of similar actively managed funds.
Let's look at an example:
Suppose an investor purchases $50,000 of two funds that both grow 7% per year before expenses over the next 30 years. The funds are similar in all respects except the expense ratio.
“Fund A” is an actively managed fund with an expense ratio of 1.2%. This fund would grow to $271,356.
“Fund B” is an index fund with an expense ratio of .2%. This fund would grow to $359,838.
That's a difference of $88,482. And it's all thanks to a low expense ratio.
The low cost of passively managed index funds can make a difference and is a reason index funds may outperform actively managed funds over long time periods.