Index funds are a common choice among long-term investors. Learn more about how to invest in index funds within different sectors and industries in this primer.
Index funds are baskets of assets designed to mimic a specific underlying index
Some well-known index funds are based on the S&P 500, Dow Jones Industrial Average, Russell 2000, and MSCI EAFE
Passively managed funds typically have low expense ratios compared to actively managed products
You’ve probably heard of index funds. Index mutual funds and exchange-traded funds (ETFs) consist of a basket of assets designed to mimic the performance of an index. But index funds are passively managed. So what is an index fund? What makes them attractive? What are the risks? And how do you know if they’re a good fit for your portfolio?
Index funds are mutual funds without the “what to own” decisions of active management. There are many types of index funds, all designed to track the movements of various sectors, markets, asset classes, or industries. Many well-known index funds are based on the S&P 500® index (SPX), which, as the name implies, is an index of roughly 500 large companies listed on U.S. stock exchanges that are weighted by market capitalization.
There are also index funds that focus on sectors, such as technology, industrials, materials, and more. Index funds can cover industry groups, such as home building or aviation, or asset classes based on commodities or currencies.
Index funds are popular because they offer a form of instant diversification. With one purchase, investors can gain exposure to a wide swath of companies.
Because index funds aren’t actively managed, they’re often referred to as “passively managed.” That means they follow an underlying index, so there’s less need for the manager to buy or sell components (unless the index itself changes).
That means fees can be kept down. Index funds typically have lower expense ratios compared to actively managed funds, where more buying and selling decisions are required to pursue the goal of outperforming an index. Plus, index funds can help diversify a portfolio without single-stock risk.
An index fund is less flexible than an actively managed fund, where a managed fund can pull out individual stocks that are underperforming and replace them with stocks they think may do better. This means there is the possibility that index funds limit upside performance potential.
While index ETFs trade throughout the day, index mutual funds trade once per day at the market close, providing investors the flexibility the choose to invest in either asset class.
How do you know if index funds are right for you?
“I always discuss taking a top-down approach when thinking about index funds,” said Patrick Mullaly, an education coach at TD Ameritrade. “The first question to ask is, are you looking to invest in an index fund or an active fund?”
Taking it from the top, investors seeking exposure to the performance of the overall stock market might choose an index fund based on a broad index like the SPX, Nasdaq-100® (NDX), the small-cap Russell 2000® (RUT), or the venerable Dow Jones Industrial Average® ($DJI).
After that, you might sit back and passively watch the index perform.
But as Mullaly pointed out, you can also use index funds for more “active” investing.
For example, you might look to an S&P 500 index fund to track the performance of the underlying index. But if you think the technology sector will outperform the SPX, you could invest in a tech-sector fund or allocate some resources to the focused fund and some to the broader index fund. The goal is to try to magnify gains and potentially benefit from an increase in the broad index—plus get a boost if the technology index also does well.
“Index funds are relatively easy to understand, and you can take a hands-off approach, but if you have the time to educate yourself and drill down, you can look into the sector indexes as well,” Mullaly said.
Mutual funds and exchange-traded funds are subject to market, exchange rate, political, credit, interest rate, and prepayment risks, which vary depending on the type of fund. Fund purchases may be subject to investment minimums, eligibility, and other restrictions, as well as charges and expenses.
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