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What Is an Index Fund?

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What we’ll cover:

Another day, another great opportunity to get smart on investing basics. On today’s agenda? Index funds. 

You may have heard that some investors turn to index funds when they’re looking for a low-cost way to build a diversified portfolio. 

But what is an index fund, exactly? Broadly speaking, it’s a type of mutual fund or ETF that’s designed to track a particular market index, like the S&P 500. In other words, index funds aren’t necessarily trying to beat the market. Instead, they’re looking to mirror the overall performance (that is, the risk and return) of the market as closely as possible. And that’s why index funds are commonly considered a type of passive investing. (We’ll get into this later.) 

If you’re thinking about investing in index funds, it’s important to make sure you understand the basics of how they work. Once you have the fundamentals down, you can decide whether they’re a good fit for your investment goals.

How do index funds work? 

Before we answer that question, it might help if we take a step back and review what a market index is. A market index is basically a collection or portfolio of investments that represent a certain part of the financial market. These indices are commonly used as market benchmarks. In other words, investors often look to them to get a general sense of how the financial markets are doing. 

The S&P 500, Dow Jones Industrial Average and the Nasdaq Composite are some of the most well-known stock indices in the US. Then there are also sector-specific indices like the Dow Jones US Technology Index, which focuses on the stock performance of certain US companies in the technology industry.

Index funds simply try to match the overall risk and return of a particular market index.

Now, you can’t invest directly in a market index since it’s a hypothetical portfolio used as a market benchmark. That’s why you typically have to invest through an index fund. For instance, say you were to invest in a S&P 500 index fund. The fund’s portfolio would include stocks (either all or a representative sample) from the S&P 500 market index, aiming to track its performance as closely as possible. 

Another good thing to know: Index funds aren’t usually actively managed. Fund managers aren’t hunched over a desk constantly researching, buying and selling individual stocks for the portfolio, hoping to outperform the market. Remember, index funds simply try to match the overall risk and return of a particular market index. Because of this approach, they’re often considered a type of passive investing. (Want to learn more about passive investing? Check out our article on the topic here.)

Why index funds are popular

Because many index funds are passively managed, they often come with lower investment fees and operating expenses than actively-managed funds. And this is one reason why they’ve caught the attention of many investors. Index funds are generally considered a low-cost investment that could help you further diversify your portfolio. 

If you’re someone who’s planning to invest for the long haul or prefers a more passive investing approach when it comes to saving for retirement or building wealth – index funds might be a good option to consider for your portfolio. 

Before investing in index funds, here are some key things to keep in mind

You can invest in index funds by buying shares through a mutual fund company or a broker. But before rushing off with your shopping cart, there are three important considerations to go over: 

  • Investment costs. While index funds tend to have lower fees and expenses than actively-managed funds, that’s not always going to be the case. So don’t skip through a fund’s prospectus. Read through it carefully and pay attention the fund’s investment fees, like its expense ratio. You might think a percentage point here or there in fees may not seem like a big deal at the moment, but fees can really add up over time and eat into your overall returns. (Psst…check out our article on investment fees where we provide an example of this.)
  • Tracking error. Remember when we said that an index fund is built to track a market index as closely as possible? Depending on certain factors, such as how the fund is built, the performance of the fund may not always match the performance of the market index perfectly. And that makes sense if you think about it. If an index fund contains only a sample of the stocks in the S&P 500 (instead of all 500), chances are the fund’s performance will likely differ from how the actual market index is doing. This is what we mean by tracking error – basically, it’s the difference between the performance of the fund vs. that of the market index. (Usually you want to look for a smaller tracking error.)

We won’t get into the math details here (it’s a standard deviation calculation). But the takeaway is: When you’re comparing index funds, the tracking error is something important to pay attention to because it can help give you a sense of how an index fund has performed over time. Now, not all funds will publicly post their tracking error data, so you may have to ask your index fund provider directly for this information

 
  • Lack of flexibility. Market volatility is a potential risk for almost all types of investments. Since an index fund tracks a particular market index, if that market – say, the stock market – sees a down swing, the value of your stock index fund will drop, too. And you may have limited flexibility to respond to these market swings since you can’t simply get rid of underperforming stocks within the fund whenever you want.

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