What Is an Index Fund?

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An index fund is a type of mutual fund or ETF that aims to track a particular market index, like the S&P 500. These funds look to mirror the overall performance (risk and return) of the market as closely as possible. In other words, index funds aren’t necessarily trying to beat the market. 

If you’re thinking about investing in index funds, it’s important to make sure you understand 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? 

First, let's review what a market index is.

A market index is basically a collection or portfolio of investments that represents 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 select US companies in the technology industry.

Be aware that 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. 

Since index funds track a market index, they aren’t usually actively managed. Fund managers aren't 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.

Read more: Active vs. Passive Investing

Why are index funds 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 term 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. 

Some things to keep in mind before investing in an index fund

You can invest in index funds by buying shares through a mutual fund company or a broker. But before rushing in, 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 may not always be the case. That's why it's important to review a fund’s prospectus.

Pay attention to 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.

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 known as tracking error – basically, it’s the difference between the performance of the fund vs. that of the market index. 

When 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. You usually want to look for a low tracking error. 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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