Index Funds – A Comprehensive Guide to Success

An infographic that explains what an index fund is. It summarizes its key characteristics, the different types of index funds, the pros and cons, and who should invest in index funds.

Investing can often be a time-consuming and tedious task, especially if you prefer to have a diversified portfolio to reduce risk. Therefore, index funds can significantly reduce your stress level. This is because most of the stock analysis work is already done for you. Besides, they are low-cost, and they prevent you from “emotional” buying and selling during ups and downs in the market.

This guide explains what index funds are, how they work, and their advantages and risks. It will help you understand what to expect from this type of investment and whether index funds are a good fit for your investment strategy and portfolio.  

What Are Index Funds and How Do They Work?

Index funds are usually structured as mutual funds or exchange-traded funds (ETF). Their goal is to replicate and match a particular market index‘s exposure and performance, such as the S&P 500 and the Dow Jones Industrial Average index.

It is impossible to invest in an index directly because an index is a hypothetical portfolio of stocks. However, investors can invest indirectly in an index by buying index funds shares. An index fund has clear rules of construction, and those rules indicate the type of companies suitable for the fund. 

Index funds are managed passively, which means they follow the benchmark index regardless of the market situation. They are managed by an index fund manager who builds a portfolio with holdings mirroring a particular index’s securities. The notion is to match the index as closely as possible so that the fund matches its performance. Some funds buy all the securities in the index, while others pick a sampling. The fund manager only buys and sells securities when the composition of the index changes. Please note that an index fund aims to match the underlying index, not to beat the market.

Investors use financial market indexes to determine how the stock market as a whole is performing or how a particular segment of the market is performing. The S&P 500 Index and the DJIA are the most common indexes tracked by index funds. Still, there are hundreds of other indexes tracking different markets, sectors, and investment types. Such a huge variety of index funds gives you the ability to build a diverse portfolio at reduced risk without too much work. Here are some other popular indexes that index funds track:

  • Nasdaq Composite. Made up of 3,000 stocks (mostly technology stocks) listed on the Nasdaq exchange
  • Russell 2000. Made up of 2,000 small-cap companies
  • Wilshire 5000. Total Market Index, the largest U.S. index made up of about 3,500 companies. You can use it as a benchmark for the entirety of the U.S. stock market
  • MSCI EAFE Index. Designed to represent the performance of large and mid-cap securities across 21 developed markets, exclusive of the U.S. and Canada
  • Bloomberg Barclays US Aggregate Bond Index. Used as the benchmark for measuring the performance of the US bond market

Buying an index fund gives you broad market exposure, reduced risks, and low operating costs in one single investment. In addition, by buying several index funds that track different indexes, you will be able to create a portfolio that matches your ideal asset allocation considering your age and risk tolerance. For example, when you are in your 20s, it might be a good idea to put 90% in stock index funds and 10% in bond index funds.

Types of Index Funds

The first index fund was created in 1976 by Jack Bogle, the Vanguard Group founder. He was a major proponent of index investing. Since then, index funds have become increasingly popular. Many companies offer index funds these days, with the most popular being Vanguard, Fidelity, and Charles Schwab.

Index funds group stocks with similar characteristics, such as the companies’ size, value, profitability, and/or geographic location. Here is an overview of the most common types of index funds with their focus:

Broad market index – A broad market index consists of many stocks in many different industries. This type of fund helps investors track movements in the overall economy. Many broad index funds focus specifically on U.S. companies and the U.S. market. An example of a broad market index is the S&P 500 index.

Market cap index – Most market index funds are weighted by market capitalization, and exposure to small-cap and mid-cap companies is often ignored. The most followed market cap index is the S&P 500. This is a large-cap index that follows 500 of the largest publicly traded companies in the United States. Another important market-cap index is the MSCI World index. This is a market-cap weighted stock market index of 1,603 stocks from companies throughout the world. 

The S&P 400 is the most popular mid-cap index, whereas the Russell 2000 Index is a benchmark for small-cap stocks in the U.S.

International index – International indexes can focus on a specific geographic region such as Western Europe, Asia, or a specific country. They can also focus on a particular international market, such as frontier or emerging markets.

Earnings-based index – There are two kinds of indexes based on earnings, growth indexes and value indexes. Growth indexes focus on companies with growth expectations that are higher than the overall market. Value indexes focus on companies with stocks that appear to be trading for less than their intrinsic or book value.

Sector-based index – Many investors buy Sector indexes to invest in a single sector’s growth prospects, such as real estate or information technology.

Socially responsible index (SRI) – These indexes represent the performance of companies with high Environmental, Social, and Governance (ESG) ratings. If you object to investing in things like alcohol, tobacco, weapons, and fossil fuels but still want to diversify a broad market index fund, a socially responsible index fund is what you should be looking for.

Index Funds versus Actively Managed Funds

Infographic that explains the differences between index funds and actively managed funds. It describes the differences with respect to goals, strategies, manager risk, main advantage, and key benefit.

Index funds generally follow a passive style of investing, as opposed to an active style of investing. They aim to track the underlying index and try to match the index’s performance, not to beat the market. An index manager tries to mimic the index’s returns by buying all or most underlying securities. The index fund manager does not continuously buy and sell securities to improve returns in the short term. However, the manager will periodically re-balance the percentage of the different asset classes to reflect the current weight of their presence in the index. 

The main goal of actively managed funds, such as many mutual funds, is to outperform or beat the market. This is done by actively selling and buying individual stocks and securities to build a customized portfolio of the industry’s strongest performing companies. This level of activity requires continuous industry and economic research and analysis.   

The main advantage of index funds over actively managed funds is the lower expense ratio. This is because index funds require only limited research and analysis. This results in a smaller administrative staff and significantly lower management fees and expense ratios than actively managed funds.

Actively managed funds often outperform index funds in the short term. However, in the long term, passively traded index funds often outperform most actively managed funds because actively managed funds are susceptible to human emotions, such as greed and ego. This is called “manager risk” and occurs because mutual fund managers try to beat the market. Indexing often removes this risk because the index fund manager’s goal is to mimic the market.

Another problem with actively managed funds is that they charge load fees of 1 to 3 percent of the total investment amount. Along with the high expense ratio, these charges can reduce an actively managed fund’s performance over the long term. Lower costs are one of the main reasons why index funds have become increasingly popular in recent years.

What Are the Advantages?

Index funds offer many advantages to investors. Here are some of the main advantages.

Lower costs – Index funds are usually considerably less costly than actively managed funds. Management fees in actively managed funds are high because the fund managers have to buy and sell stocks to outperform the market continuously. This requires a large staff of researchers and analysts. In contrast, an index fund manager only has to rebalance the fund’s portfolio to match the index periodically. Besides lower management fees, the transaction fees and commissions for an index fund are significantly lower. 

Typically, expense ratios for index funds range from 0.10% to 0.75%, whereas most actively managed funds have expense ratios between 1% and 2.5%.

Easy Diversification – The diverse make-up of an index fund minimizes risk. When one stock is down, another one is probably up. Besides, a broad market Index fund covers an extensive market, including most sectors of the economy. A slowdown in one sector, therefore, will not significantly impact the fund as a whole. 

Another way index funds can offer easy diversification is to buy an index fund that focuses on an asset class that is not part of your portfolio yet. For example, you might own a diversified stock portfolio, but you buy a bond index fund to diversify across different asset classes. Portfolio diversification minimizes risk for the investor.

Easy investment that saves time – ETF index funds trade like individual stocks and can be easily bought and sold at any time. In one transaction, you can track a large basket of stocks. Not much research is necessary as the fund tracks a well-known index. Most transactions are commission-free, which makes it even easier. There is no need to worry about what securities to buy and sell and the best timing for those transactions. With passive investing, you invest the money in a diversified fund and then sit back and relax.

Dependable performance – Index funds are passively managed funds and generally get the same return as the index they track. Their goal is to match the market performance, not to beat the market. Please note that you have to subtract the fund’s expense ratio from the return to get the real return. 

Historically, index funds have outperformed actively managed funds in the long run. Warren Buffett, the Chairman, and CEO of Berkshire Hathaway, has always supported index funds. During his company’s annual meeting on May 2, 2020, Buffett said, “In my view, for most people, the best thing to do is to own the S&P 500 index fund.” While stock prices can fluctuate a lot in the short term, the 30-year average annual return (1991-2020) for the S&P 500-stock index, which is generally considered a benchmark for overall market performance, is just under 11%. For the last 10 years (2011-2020), it is just under 14%!

Transparency – Most index funds match the index’s underlying securities, so it is easy to know exactly what securities the fund is holdings at any time. Such transparency makes it easy to evaluate the risks associated with the fund.

Lower tax exposure – These funds do not trade securities frequently, resulting in lower capital gains taxes than actively managed funds. This means your fund can grow without significant tax implications.

Less human error –  Fund managers of actively managed funds always compete with one another as they always try to beat the market. They try to do this by frequently buying and selling securities and trying to time the market. Making mistakes is easy to do, and emotions, egos, and greed will often take over. This may result in the fund manager making irrational decisions to follow the herd. It is not uncommon for human error to negatively impact an actively managed fund.

In contrast, an index fund manager’s main goal is to build a portfolio with holdings matching a particular index’s securities and returns. Because fund managers do not have to compete, there is less chance for human error. 

What Are the Disadvantages?

Like any other investment, index funds have some disadvantages and are subject to some risks. Here are some of those disadvantages and risks: 

Never outperform the market – Index funds do not beat their benchmark’s performance, as they merely try to match the index’s performance. So if you want to show off as an investor and beat the market, index funds are not for you. Although high returns are possible when the market index goes up, you are guaranteed a loss when it goes down. 

Lack of flexibility – As the fund aims to mimic the index it tracks, investors can neither sell an underperforming stock in the index nor add a rising stock. There is no flexibility as to what stocks are in the fund.

No downside protection – When the index goes down, the index fund goes down as well. An index fund cannot be responsive to downward or upward trends of the index’s underlying securities, as it has mimic the index. Actively managed funds can be more responsive to expected market drops. They can prevent losses by selling stocks that are falling and buying stocks that are going up.

Tracking Error – An index fund may not perfectly track its index because a fund may only invest in a sampling of the index’s underlying securities. This can result in the fund’s performance not matching the index’s performance.

Underperformance – Some index funds may underperform their index because of fees, expenses, transaction costs, and tracking errors.

How to Invest in Index Funds?

Index funds have increasingly become more popular and certainly have their advantages. Here are some tips on how you can invest in them.

1. Select an index

Different index funds let you track hundreds of different indexes. Some of the top tracked indexes include the DJIA, S&P 500, Willshire 500, and the Nasdaq Composite.

Apart from these broad market indexes, you can buy indexes that have a different focus. For example, sector indexes associated with different industries, such as the Vanguard Financials Index (VFAIX) and the iShares US Technology ETF (IYW). Other types are investment-strategy-focused indexes, such as indexes focusing on value-priced stocks or growth stocks, or any other type of index that fits your needs and portfolio.

2. Pick the right fund

After you have selected the type of index you want to track, you will typically find multiple funds to choose from. For example, for some of the most popular indexes, such as the Standard & Poor’s 500, you might find dozens of funds. If you find multiple fund options for a single index, you can base your choice on some of the following considerations: the funds’ past performance, what fund has the lowest costs, fund limitations, and what other index funds the fund provider offers. 

Before investing in any index fund, it is crucial to carefully research all the fund’s available information. Especially the fund’s prospectus and most recent shareholder report are important information sources. Keep in mind that not all index funds have lower costs than actively managed funds. Always make sure that you understand the actual cost of any fund before investing.

3. Buy stocks of the selected fund

Once you have selected the index fund, there are two ways you can buy shares. You can either open an account with the fund provider or open an online brokerage account such as a TD Ameritrade account.

Some brokers charge a fee to buy index fund shares. This may be more expensive than opening an account directly with the fund company. However, most investors want to have all their investments held in a single account, in which case, a brokerage account might be the best solution.

Who Should Invest in Index Funds?

In recent years, index funds’ growing popularity has proven that this form of investment appeals to many investors. Moreover, because index funds are accessible to almost everybody, they are a great choice for many types of investors.

New Investors – Investing in individual stocks is generally not a good idea if you are new to investing. This is because it requires a lot of time, effort, knowledge, research, and analysis. In addition, when investing in individual stocks, you also need to closely monitor the market, which is also very time-consuming. Instead, an index fund can offer you a diversified portfolio at minimum effort and risk with a dependable return.

Passive Investors – Many people are interested in investing but don’t have the time or knowledge to do it. Index funds are great for passive investors as index fund managers take care of the investment for you and save you time and anxiety. The fund manager will buy the underlying securities of the index and will rebalance its portfolio when necessary. Then, as a shareholder, you can sit back and relax.

Intermediate Investors – If you fall somewhere between a new and a self-directed investor, index funds are an amazing investment option as well. You can start by holding most of your money in these funds, and then after educating yourself by tracking the funds you own, you can slowly begin self-directed investments with small amounts of money. Then, with growing expertise, you can slowly transition your portfolio into a self-directed portfolio, or you can decide to keep both the self-directed and index fund portfolios.

Retirees – Gone are the days when retirees preferred safe investments with about 5 to 10% return. Today, retirement investing has changed. Safe investments do not have the returns anymore that are needed. That is why so many retirees invest a larger percentage of their investments into the stock market to increase their returns. Index funds are undoubtedly one of the best ways to do this. It lets them maintain the desired percentage in stocks without having to manage the investment actively.

Conclusion: Are Index Funds a Good Investment?

Over the past decade, mutual funds and ETF index funds have constantly outperformed actively managed funds in the long term. Therefore, Index funds are a great investment opportunity for investors of any skill level.

If you want to grow your money without spending a lot of time and effort in research, index funds can provide an effective solution for reaching your financial goals and investment objectives. Index funds have a lot of advantages but also have some risks and limitations. Make sure you understand everything about index funds before investing in them. If you are not sure how to pick the right fund, you can always hire a financial advisor to help you find the ideal index fund for you.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.