Index funds, once dismissed as an unimaginative way to invest, have quietly revolutionized U.S. equity markets. These funds aim to mirror the performance of benchmarks like the S&P 500 by mimicking their makeup. Their appeal has surged, drawing the attention and dollars of a widening swath of investors. The numbers tell a compelling story: in 2012, passive index funds tracking market benchmarks accounted for just 21% of the U.S. equity fund market. By 2023, passive funds had crossed above 50% of assets, outpacing their actively traded peers. This seismic shift has come as index funds have consistently outperformed their active fund counterparts.
According to the widely followed S&P Indices Versus Active (SPIVA) scorecards, about 9 out of 10 actively managed funds didn’t match the returns of the S&P 500 benchmark over the previous 15 years. Critics argue that rather than demonstrating unique stock-picking wizardry, managers of actively traded funds have shown a knack for extracting higher fees for themselves while delivering less to clients. For many investors who once believed in the value of these fees, the spell has been broken.
Understanding Index Funds
An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to track the returns of a market index. These funds offer a way to invest indirectly in a market index, providing broad market exposure and diversification. Market indexes measure the performance of a “basket” of securities, such as stocks or bonds, representing a sector of a stock market or an economy. For instance, the S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are popular market indexes that index funds might track.
Index funds typically take a passive investing approach, meaning they aim to maximize returns over the long run by not actively picking securities or timing the market. Instead, they invest in all or a sample of the securities included in a market index. Some index funds also use derivatives, like options or futures, to help achieve their investment objectives.
Benefits of Index Funds
The primary advantage index funds have over actively managed funds is lower fees. Managers of index funds don’t need to employ research analysts or frequently trade securities, which reduces costs. This lower cost structure means investors pay lower expense ratios—typically around 0.05% or less, compared to 0.44% or higher for actively managed funds. Despite their passive approach, index funds often outperform actively managed funds over the long term, especially after accounting for fees and expenses.
Other benefits of index funds include:
Market Representation: They aim to mirror the performance of a specific index, offering broad market exposure.
Transparency: Since they replicate a market index, their holdings are well-known.
Historical Performance: Over the long term, many index funds have outperformed actively managed funds.
Tax Efficiency: Lower turnover rates usually result in fewer capital gains distributions, making them more tax-efficient.
Drawbacks of Index Funds
Despite their advantages, index funds have some drawbacks. Their inherent lack of flexibility means they can’t pivot away in an unfavorable market environment. Index funds automatically include all securities in an index, which means they may invest in overvalued or fundamentally weak companies. Additionally, market-cap-weighted index funds can be overly influenced by a few large companies, magnifying risks if these companies underperform.
Best Index Funds
Here are some of the best index funds, noted for their performance and low expense ratios:
Vanguard 500 Index Fund Admiral Shares (VFIAX): Minimum investment $3,000, expense ratio 0.04%, 10-year average annual return 12.60%.
Fidelity Nasdaq Composite Index Fund (FNCMX): No minimum investment, expense ratio 0.29%, 10-year average annual return 15.16%.
Fidelity 500 Index Fund (FXAIX): No minimum investment, expense ratio 0.015%, 10-year average annual return 12.69%.
Vanguard Total Stock Market Index Fund Admiral (VTSAX): Minimum investment $3,000, expense ratio 0.04%, 10-year average annual return 12.06%.
Schwab S&P 500 Index Fund (SWPPX): No minimum investment, expense ratio 0.02%, 10-year average annual return 12.73%.
Are Index Funds Good Investments?
Index funds are popular among investors for their simplicity and cost-effectiveness. They offer a low-cost way to gain exposure to a broad, diversified portfolio. In bull markets, these funds can provide attractive returns as the market rises. However, they also come with disadvantages, such as a lack of downside protection in prolonged downtrends.
Index Mutual Funds vs. Index ETFs
If you’re interested in index funds, you’ll need to choose between investing in mutual funds or ETFs that track specific indexes. Both types replicate the performance of a market index but differ in several key aspects.
Index Mutual Funds: These pool money to buy a portfolio of stocks or bonds and are priced at the net asset value (NAV) calculated at the end of each trading day. They are ideal for dollar-cost averaging and automated dividend reinvestment.
Index ETFs: These are traded on exchanges like individual stocks, allowing for real-time trading flexibility. ETFs offer more trading strategies and can be bought in individual shares, making them more accessible.
Example of an Index Fund
The Vanguard 500 Index Fund, founded by Vanguard chair John Bogle in 1976, remains one of the best examples of an index fund. It tracks the S&P 500 faithfully in composition and performance. As of March 2024, Vanguard’s Admiral Shares (VFIAX) posted an average 10-year average annual return of 12.75% vs. the S&P 500’s 12.78%, with a very small tracking error and a low expense ratio of 0.04%.
How To Invest in Index Funds
Investing in index funds is straightforward:
Choose Your Investment Platform: Select an online brokerage or investment platform.
Open and Fund an Account: Provide personal information, set up login credentials, and complete a questionnaire about your investment goals and risk tolerance. Deposit funds through a bank transfer.
Select an Index Fund: Research different funds to understand their performance history, management fees, and the indexes they track. Consider diversifying your portfolio by investing in several index funds.
Buy Shares: Purchase shares of your chosen fund through the platform’s website or app.
Monitor and Adjust as Needed: Periodically review your portfolio to ensure it aligns with your financial goals.
Are Index Funds Better Than Stocks?
Index funds offer the benefits of diversification, reducing overall risk while increasing expected returns. They protect against the steep price drops of individual stocks, as the impact is mitigated within a larger index.
Best Index Funds for Retirement
The best index funds for retirement offer growth potential and solid risk management. Broad-market equity index funds like the Vanguard Total Stock Market Index Fund (VTSAX) or the Fidelity 500 Index Fund (FXAIX) are good for long-term growth. For diversification and income, consider bond index funds like the Fidelity Total Bond Fund (FTBFX). Target-date retirement funds, which adjust their allocation as your retirement approaches, can also be a convenient option.
Are Index Funds Good for Beginners?
They are excellent for beginners due to their simplicity, cost-effectiveness, and diversification. They have lower expense ratios than actively managed funds and often outperform them, making them a solid choice for both novice and expert investors.
How Much Should You Pay for an Index Fund?
They generally have low annual fees, averaging around 0.04%, with some even lower. All else being equal, choosing the lower-cost fund among those that equally track the same index is prudent.
The Bottom Line
They are a popular choice for low-cost, diversified, and passive investments that often outperform higher-fee, actively traded funds. They replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing. While they offer advantages like lower risk through diversification and solid long-term returns, they also lack the flexibility of active management. Despite these limits, they are often favored for their consistent performance and are now a staple in many investment portfolios. Always consider your investment objectives and risk tolerance when choosing an index fund, and seek personalized advice from a financial advisor when needed.
How Do Index Funds Invest?
It generally follow a passive investing strategy, aiming to maximize returns over the long run by not frequently buying and selling securities. This contrasts with actively managed funds, which seek to outperform a market by making more frequent trades.
What Are the Costs Associated with Index Funds?
It typically have lower costs due to their passive investing strategy. Managers don’t need to employ research analysts or frequently trade securities, reducing overall costs to shareholders. However, not all index funds have lower costs than actively managed funds, so it’s essential to understand the actual cost of any fund before investing.
What Are Some Risks of Index Funds?
Like any investment, it involve risks. They may lack the flexibility to react to market declines and can experience tracking errors, where the fund’s performance doesn’t perfectly match the index. Additionally, index funds may underperform their index due to fees, expenses, and trading costs.
Before You Invest
Before investing in any fund, carefully read all available information, including the fund’s prospectus and most recent shareholder report. Funds disclose their portfolio holdings quarterly, and this information can usually be found on the fund’s website or through your financial professional.
