Index funds—those typically low-expense-ratio, passively managed funds that attempt to mirror the performance of stock indices—are a common choice among long-term investors. Here’s a quick 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. Much like other mutual funds and exchange-traded funds (ETFs), index funds consist of a basket of assets designed to mimic the performance of an index. But index funds are passively managed. So what are index funds? 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 top 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, 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, like 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 own 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 low expense ratios compared to actively managed funds, where more buying and selling decisions are required to meet the goal of outperforming an index. Plus, index funds can help diversify a portfolio without single-stock risk.
In recent years, most index funds have enjoyed solid gains following the U.S. bull stock market. The S&P 500 Index has had an annualized average return of around 10% since its inception in the 1920s through 2019, according to data from Yahoo! Finance. But from 2000 to the middle of 2020, the SPX more than doubled.
Of course, index funds carry all the same risks as the underlying indices. An index fund is also less flexible than an actively managed mutual fund, where a manager can pull out individual stocks they think will underperform and replace them with stocks expected to do better, so the upside is limited as well.
Index funds, like other mutual funds, differ from ETFs, which trade throughout the day. Index funds trade once per day, at the market close. Mutual funds are often actively managed, so they often have higher operating costs than index-based mutual funds.
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 a passive or active investor?”
Taking it from the top, investors interested in benefiting from 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 performance of the index.
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 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 indices as well,” Mullaly said.
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