What is an Index Fund?

An index fund is a type of ETF (exchange traded fund) that is designed to track the performance of a specific market index.

They are considered to be ideal holdings for “set it and forget it” investors.

The first index fund, which is still being traded today, is the Vanguard 500 fund.

This fund was created to track the performance of the S&P 500.

Rather than investing in all 500 companies separately, the fund allowed investors to gain a bit of exposure to all of them

The best index funds have low operating expenses, low portfolio turnover, and broad market exposure.

Rather than picking one specific stock, index funds invest your money among the dozens, or even hundreds of companies.

One of the main benefits of investing in a broad range of companies is the ability to diversify your portfolio and reduce risk.

An index is a measure of a specific segment of the stock market.

Indexes such as the Dow Jones Industrial Average, NYSE, or the NASDAQ are often cited by the media and used by investors to gauge the performance of the overall market.

Indexes contain a number of different stocks.

The percentage a certain company takes up in an index is known as its weight.

Weighting is a method for adjusting the impact of an individual item on the index.

Some values are based on market cap weighting, some based on revenue weighting, and so on.

What is the S&P 500?

The S&P 500 is an index comprising of the 500 largest publicly traded companies by market cap in the US.

The index weighs companies by the number of shares in circulation for public trading so each of the 500 companies does not have a 1/500 weighting.

The S&P 500 is considered one of the best gauges of the health of the equities market and large US stocks.

While investing in it directly isn’t possible, it is possible to invest in one or more of the many funds that use it for guidance.

Key Things to Know About Index Funds

Directly investing in indexes is not possible however investing in index funds that mimic market indexes has become a popular tool for many investors.

They are usually passively managed which lowers the fees paid and MER (management expense ratio) and generally generate high returns.

They are a well-rounded way to invest and minimize risk since their holdings are diversified.

Index funds are also easily purchasable through an investment account at a traditional brokerage.

Many new traders find picking individual stocks to be a daunting task.

Researching the company, its financial performance, earnings reports, management team, and strategic plans are just some of the many steps traders will take before deciding whether or not a stock is worth investing into.

Even after all that effort, there is no guarantee the stock you choose is a good one.

Sometimes, all it takes is one bad news event to send the stock tumbling.

Even worse, a scandal or bankruptcy like Enron could mean that the company’s stock drops to pennies and your money can never be recovered.

This is made even more dangerous when traders decide to put all their eggs into one basket.

While some companies may seem too big to fail now, there is no such thing in the market as a risk-free investment.

To reduce the risk inherent in picking individual stocks, index funds are a great alternative.

The goal of index funds is to mirror the performance of the market they track as a whole.

For example, if the S&P 500 goes up 2 percent a day, an index fund that tracks the S&P will also go up 2 percent.

Rather than investing in all 500 companies that comprise the S&P 500 individually, index funds give traders a much easier way to invest in the markets that they are interested in.

These index funds are listed on exchanges and can be purchased just like any other stock.

All you need to do is find the ticker of the index fund you are interested in and make your purchase.

This easy process makes index funds an appealing option to individuals interested in a more passive investing style.

Index funds are often compared to Exchange Traded Funds (ETFs), and the terms are sometimes used interchangeably.

The two share many similarities, but one important difference is that index funds are usually not actively managed.

This means that there is no fund manager responsible for picking out new companies to add or remove from the index fund.

In contrast, some ETFs are actively managed, meaning there are money managers who are in charge of the index with the goal of generating a higher return.

Depending on the type, some ETFs can even be rebalanced daily.

As a result of the passive nature, index funds generally have lower management fees and operating costs (known as Management Expense Ratios, or MERs) than actively managed ETFs.

While index funds are inherently safer than picking individual stocks, investors will still have the ability to make decisions based on their risk tolerance.

For example, an index fund that tracks US-based markets will be seen as much more stable than an index fund that tracks emerging markets.

Pros of Investing in Index Funds

Less Risk

One of the main reasons investors choose to hold index funds rather than individual stocks is the lower risk associated with them.

Market index funds are protected from sudden price drops that might occur with individual stocks due to poor earnings reports or other news.

Rather than having all eggs in one basket, index funds allow for a more steady approach to investing.

Steady Growth

Index funds are a great way to take a long-term approach to investing.

Rather than focusing on short-term price fluctuations, index fund investors look at the long-term growth of the entire market.

Over the past several decades, historical returns have shown that index funds continue to grow at a steady pace.

While you won’t see massive profits overnight, index funds will give you a great chance of steady long-term growth.

Using techniques like dollar cost averaging, index funds are a great “set it and forget it” strategy for investors.

No Need to Pick Individual Companies

With index funds, there is little need to research individual companies and spend hours deciding where to place your money.

Index funds are designed to spread your money amongst hundreds or sometimes thousands of companies, taking out the stress of picking winners in a crowded marketplace.

For this reason, index funds are often recommended for newer investors or those who have less time to commit to investing.

Cons of Investing in Index Funds

Less Upside

Having less risk is one of the greatest benefits of index funds.

However, the flip side of that is the fact that investors may miss out on big gains on individual names.

Hearing news about a stock going up 50, 60, or even 90 percent in a day may lead to a fear of missing out (FOMO) syndrome.

While riskier, successfully picking individual names that break out will yield greater returns than index fund investing.

However, the long-term success of index fund investing is hard to replicate through individual stock trading.

No Flexibility During Downturns

As the main goal of index funds is to mimic the performance of the index it is trying to track, there is little flexibility when the stock market is performing poorly.

While actively managed ETFs are able to react to economic shocks and market downturns, index funds are forced to continue following the market down.

This can lead to losses in the short term.

While this is not an issue for long-term investors, emergency situations where access to funds is required may mean losses have to be locked in.

Seeing account balances drop during an economic downturn can be a very stressful situation.

Limited Exposure

Investing in index funds can sometimes result in missing out on opportunities.

For example, indices that track the S&P 500 only provide exposure to the 500 largest companies in the United States.

This means that you are limiting yourself and losing the chance to hold small-cap stocks in your portfolio.

Investors may need to look for more niche or specific funds if they want to gain exposure to less traditional indices.

Lack of Control

While index funds may generate returns an investor is looking for, the downside is that you are not given the opportunity to choose what is being held in your portfolio.

For example, if an investor does not want to hold a specific sector (i.e. tobacco, oil and gas companies), they are limited in their options.

As these large corporations are a part of many index funds, those who want to exercise personal choice have limited options.