Index funds are mutual or exchange-traded funds designed to mimic the performance of a given stock market index.
Index fund investing is a form of passive investing, since the fund manager is not making independent decisions about whether to buy or sell specific securities, but rather doing so in order to keep the fund in line with the index on which it is designed.
What Are Index Funds?
Index funds allow investors to benefit from diversification within the portfolio without making individual investments in hundreds of companies. Rather than actually investing in every company in an index (the Dow Jones Industrial Average or the S&P 500, for example), index funds allow investors to allocate portions of their portfolio across more companies.
They’re a great way for beginner investors to get exposure to the stock market without having to do in-depth investment on multiple individual companies. Let’s say you’re an investor who wants to invest in the 500 stocks that comprise the S&P 500. Rather than buying 500 stocks, you can invest in an index fund that mirrors the S&P 500 and holds the same stocks, giving you exposure to the benchmark index, with all the risk and benefits that they offer.
Because they aim to mirror the broader markets, index funds may offer lower returns (or lose money) in a bear market vs a bull market, where performance can be better. However, since there are fewer transactions within the fund (since the underlying indexes don’t frequently change) and fewer managers doing research on securities within the fund, they tend to be a fairly low-cost way to invest.
What Are the Most Common Stock Indexes?
While there are benchmark indexes for just about every sector of the economy and the financial markets, the most common financial indexes tracked by index funds include the following:
Dow Jones Industrial Average
The DJIA represents an index of 30 of the most profitable companies in the U.S. The index is spread across different business categories, with companies in the technology, health care, consumer goods, retail, and financial sectors are all represented in the DJIA.
NYSE Composite Index
This index tracks the performance of all the common stocks on the New York Stock Exchange. Stocks in the NYSE index are what economists call “capitalization-weighted”, meaning each stock’s inclusion in the index is weighted in proportion to its stock market capitalization.
S&P 500 Composite Stock Price Index
The S&P 500 index includes 500 stocks that are also capitalization-weighted, representing top-level U.S. companies in a wide variety of industries. S&P 500 stocks reflect a variety of economic metrics, including market size, financial performance, cash and liquidity, and business sector.
Wilshire 5000 Total Market Index
The Wilshire Index tracks the performance of the total U.S. market. For inclusion in the index, companies must be headquartered in the United States and be a publicly-traded company. Like the DJIA and the S&P stock indexes, the Wilshire Index is capitalization-weighted.
The Russell 2000 Index
This index tracks the financial performance of 2,000 smallest publicly-traded U.S. companies. The primary metric is market capitalization size.
The Nasdaq-100 Index
The Nasdaq Index mirrors 100 of the most widely-traded U.S. and international companies that trade on the Nasdaq Stock Market. To qualify for index inclusion, a company must have a minimal daily trading volume of 100,000 publicly-traded shares, trade on the Nasdaq exchange, or have traded on another prominent exchange for a period of at least two years.
Index Funds vs ETFs vs Actively Managed Funds
Most investment funds fall into one of three categories, index funds, ETFs, and actively managed funds. Each type of investment has its benefits and drawbacks.
Investors who opt for index funds rely on their funds to track specific financial benchmarks (also known as indexes), like the S&P 500, the Dow Jones Industrial average, or the Russell 2000 Small Cap Stock Index. For index investors, the goal is to keep pace with market returns by tracking and mirroring financial market segments.
Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) are similar to index funds, in that they allow investors to get portfolio exposure to a wide range of stocks, often tracking an index. The difference between ETFs and index funds is that investors can buy and sell ETFs throughout the day, like stocks, while index fund trades must take place at a set price at the end of a trading day.
Actively Managed Funds
Actively managed fund managers attempt to beat, and not just keep pace with, market returns. The managers who run them are active investors, who make decisions about each security based on their research and view of economic, market, and company factors.
What Are the Pros and Cons of Index Funds?
There are several benefits to investing in index funds rather than active funds, but there are also some drawbacks worth keeping in mind. Whether it makes sense to invest in one, the other, or both depends on your investment goals.
The Pros of Index Funds
• Fairly dependable performance. Since index funds track specific indexes, their returns mirror those indexes over a specific period of time. That could mean gains or losses, but in all likelihood, there may not be significant surprises that fund managers or investors didn’t anticipate, given the public listing of index numbers on a daily basis.
• Lower fees. Since index funds aren’t actively managed by a team of analysts and fund managers, these funds cost less to operate. The asset-weighted average expense ratio for active funds was 0.13% in 2019, less than a fifth of the .66% average of actively managed funds, according to a recent Morningstar Report.
• Full transparency. Index funds typically hold securities included in the index they track. Those publicly-traded securities are widely available to review on a daily basis, thus allowing an easy and transparent way for investors to weigh any risks or concerns of investing in the fund.
• Potentially better returns. While the returns of an individual fund depend on the overall market and the decisions of the manager, in general, index funds tend to perform better than actively managed funds.
The Cons of Index Funds
• You’re stuck with the securities in the fund. Index funds always reflect the benchmarks they track, and fund managers don’t usually sell securities in the fund even if they lose value. That’s where index funds differ from managed funds. Unlike index funds, managers of actively managed funds can try to swap out losing securities for winning ones if needed. If you are an investor who likes to time the market, index fund investing is likely not the best strategy for you.
• Your returns will rarely beat the market. The goal of an index fund is to match the performance of an index, not to exceed it. That means when investing in a down market, an index fund will likely be down as well.
• Potential for tracking error. If a manager fails to select securities that properly track an underlying index, its performance may not match the performance of the index.
How to Invest in Index Funds
First, consider which index you’d prefer to track. You might choose a broad index that tracks the overall market, or select one or more sector-specific index that gives you more exposure to a specific area of the economy. You can also choose an index that focuses on companies based on other factors, such as their market capitalization or their performance on sustainable investing factors.
After that, look for a fund that tracks that index, evaluate the fee structure and purchase it via your preferred brokerage platform. Like any fund investment, you’ll want to weigh the investment risks associated with the fund (and its underlying index). Check historical returns for the fund and review its investment goals and see how they match up with our own preferred investment goals.
It’s also a good idea to review the fund’s regulatory and management history to check for any violations or red flags. The U.S. The Securities and Exchange Commission offers a handy fund research tool to research any fund – find it here .
Index funds are a way for even novice investors to get low-cost exposure to broad swaths of the economy within their portfolio. It’s important to understand their benefits and drawbacks, when deciding whether or not they make sense as part of your portfolio.
If you’re ready to start investing in index funds, a great way to start is by opening a brokerage account with as little as $5 on the SoFi Invest investment platform. You can also use the platform to invest in other types of securities as well, including individual stocks, fractional shares, even Cryptocurrencies and Initial Public Offerings.
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