Index funds can offer a simplified approach to portfolio building when the primary goal is to meet, rather than beat, the market’s performance. In simple terms, these mutual funds or exchange-traded funds (ETFs) seek to track the performance of a particular stock market index or benchmark.
The performance of index funds can vary based on which index the fund tracks and how the stock market performs as a whole. While these funds can offer some insulation against volatility, it’s important to understand which factors drive index funds returns.
What are Index Funds, Exactly?
An index fund is a type of mutual fund that’s designed to track the performance of a stock market index, by investing in some or all of the securities tracked by that particular index.
An index represents a collection of securities, which may include stocks, bonds, and other assets. Stock indexes can cover one particular sector of the market or a select grouping of companies. Examples of well-known stock indices include the S&P 500 Index and the Russell 2000 Index.
What Determines Index Fund Returns?
Even though they tend to have a similar purpose and function inside a portfolio, the return on index funds isn’t identical from one fund to the next. Factors that can influence index funds’ returns include:
• Which index they track
• Whether that index is:
◦ Cap-weighted, in which each security is weighted by the total market value of their shares.
◦ Price-weighted, in which the per share price of each security in the index determines its value.
◦ Equal-weighted, in which all of the securities being tracked are assigned an equal weight for determining value.
• Number of securities held by the fund
• Geographic classification of fund securities
• Expense ratio and fees
• Overall market conditions
• Tracking error
Together, these factors can influence how well one index fund performs versus another.
First, consider which benchmark an index fund tracks. There can be significant differences in the makeup of various indexes. For instance, the S&P 500 covers the 500 largest publicly traded companies while the Russell 2000 Index includes 2000 small-cap U.S. companies.
Large-cap stocks can perform very differently from small-cap stocks, which translates to differences in index fund returns. Between the two, large-cap companies tend to be viewed as more stable while smaller-cap companies are seen as riskier. Large-cap companies may fare better during periods of increased market volatility but in an extended downturn, small-cap companies may outperform their larger counterparts.
Cap-weighted, price-weighted, and equal-weighted indexes all have the potential to perform differently, because each company’s stock may have different weight in each of these types of funds. For example, if a stock in an equal-weighted index filled with 500 stocks performs poorly, those shares represent 1/500th of performance. On the other hand, if the same stock performs poorly in a cap-weighted fund and it happens to have a very high market cap, it may represent a larger percentage of performance.
For these reasons, it’s also important to know how many securities are held by the fund. The more securities in a given fund, the greater the likelihood that a poorly performing one will be balanced by others.
Even when two index funds both follow the same formula with regard to market capitalization, returns can still differ if each fund offers a different geographic exposure. For example, a fund that tracks a global market index and includes a mix of international and domestic stocks may not yield the same results as an index fund that focuses exclusively on U.S. companies.
Funds that track global indexes can also differ when it comes to how they characterize certain markets. For instance, what one fund considers to be a developed country may be another index fund’s emerging market. That in turn can influence index fund returns.
Expense Ratio and Fees
Index funds are generally passive, rather than active, since the turnover of assets inside the fund is typically low. This allows for lower expense ratios, which represent the annual cost of owning a mutual fund or ETF each year, expressed as a percentage of fund assets. Generally, index funds carry lower expense ratios compared to actively managed funds but they aren’t all the same in terms of where they land on the pricing spectrum.
The industry average expense ratio for index funds is 0.57%, though it’s possible to find index funds with expense ratios well below that mark. The higher the expense ratio, the more you’ll hand back in fees to own that index fund each year, reducing your overall returns.
In terms of fees, some of the costs you might pay include:
• Sales loads
• Redemption fees
• Exchange fees
• Account fees
• Purchase fees
When comparing index fund costs, it’s important to keep the expense ratio, fees, and historical performance in mind. Finding an index fund with an exceptionally low expense ratio, for instance, may not be that much of a bargain if it comes with high sales load fees. But a fund that charges a higher expense ratio may be justifiable if it’s consistently outperformed similar index funds year over year.
Tracking error can significantly impact your return on index funds. This occurs when an index fund doesn’t accurately track the performance of its underlying index or benchmark.
Tracking errors are often tied to issues with the fund, rather than its index. For example, if a fund’s composition doesn’t accurately reflect the composition of the index it tracks than performance results are more likely to be skewed. Excessive fees or a too-high expense ratio can also throw a fund’s tracking off.
What Are Good Index Fund Returns?
What is a good return on investment for an index fund? Given that the return on index funds can vary, the simplest answer may be to look at the stock market’s historical performance as a whole.
The S&P 500 Index is often used as a primary market benchmark for measuring returns year over year. The average annualized return for the S&P 500 Index since its inception—including dividends and adjusted for inflation—is 8.7%. Following that logic, a good return on investment for an index fund would be around the same.
You could also use the fund’s individual index as a means of measuring its performance. Comparing the fund’s performance to the index’s performance month to month or year over year can give you an idea of whether it’s living up to its expected return potential.
Are Index Funds a Good Investment?
Index funds may appeal to one type of investor more than another, which is why it’s always important to do your research before determining what will be a good fit for your portfolio.
Investors who prefer a low-cost, passive approach may lean toward index investing for growing wealth long-term. Index funds can offer several advantages, including simplified diversification and consistent returns over time.
For example, if your investment goals include keeping costs low while producing consistent returns with lower fees, then index investing could be a good choice. You may also appreciate how easy it is to buy index funds or ETFs and use them to create a diversified portfolio.
Index funds can help with pursuing a goals-based investing approach, which focuses on investing to meet specific goals rather than attempting to beat the market. When comparing index funds, pay attention to the fund makeup, its costs, historical performance, turnover ratio and the potential for tracking errors.
A number of factors helps explain why different index funds have different returns—including but not limited to which index they track and how it’s weighted, the geographic classification of the fund securities, expense ratios, and overall market conditions.
Unless you have a crystal ball, there’s no way to predict exactly how an index fund will perform. But getting to know what differentiates one index fund or ETF from the next can help with making more informed decisions about which ones to buy.
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