More and more investors are choosing to put their money in index funds. In late 2016, for every one hundred dollars that was invested in equity markets, twenty was being put into index funds. In that year, $236.7 billion flowed into U.S. stock market index funds. Their popularity stems from their ability to deliver predictable results at a lower cost than traditional mutual funds.
In this article, we’ll define what an index fund is, how it’s different than a traditional mutual fund, the benefits of index funds and why they may not be right for every investor. We’ll also discuss how to pick an index fund.
What is an index fund?
An index fund is a type of mutual fund that includes a portfolio of equities designed to match or track a specific market index. One of the most popular indices used by index funds is the Standard & Poor’s 500 Index (S&P 500). Another common index used is the Dow Jones Industrial Average.
How are index funds different from traditional mutual funds?
Mutual funds were developed as a way to offer greater diversification (and therefore, a greater sense of security) to investors, even those with just a modest sum to invest. Individual investors would no longer have to painstakingly research individual securities. Instead, they could buy into a mutual fund. Professional fund managers would assemble a portfolio of securities that met the fund’s objectives, and voila, investors could sleep easily and watch their money grow. It was a great idea. In fact, author Theodore J. Miller, writing for Kiplinger's, heralded mutual funds as “The Best Investment Idea Anyone Ever Had.”
But for the average investor, mutual funds have one problem that can be summed up in two words: active management. It’s not really the active management that is the problem, it’s the cost of the active management. Professional fund managers need to be paid as professionals. Index funds offered an alternative.
Unlike an actively-managed mutual fund that relies on professional fund managers to select and manage the portfolio, an index fund is set up simply by buying the individual components of the chosen index and holding them in proportion to their value in the index. An index fund must also have a plan set up for rebalancing to match the index because not all stocks grow at the same rate and the index’s list will change from time to time. And how is the index list made? Committees at third-party companies such as S&P Dow Jones Indices are the ones who compose a list of rules or standards that they use to put together a certain index. These index-making companies are paid a licensing fee whenever their indexes are used in an investment product. In creating the index, they do not attempt to make a list of stocks that will do well, but just a list of stocks that represent the market or the market segment.
The Dow Jones Industrial Average is simply a list of the thirty blue-chip stocks that are selected by the editors of The Wall Street Journal. The shares are given a weight based on their stock price and adjusted for such things as stock splits. But otherwise changes to the index are pretty rare. Likewise, the S&P 500 Index is a list of 500 large companies listed on the NYSE or NASDAQ, and it usually only changes when one of the included companies is acquired.
This chart helps show the two biggest differences between index funds and actively managed mutual funds.
Annual Expense Ratio
0.11% on average
Match the return of an index (before fees)
Actively Managed Fund
Beat the return of an index (before fees)
Here’s what you can take away from this chart: there is an extremely high bar that an actively managed fund has to cross in order to beat an index. For some historical perspective, since 1871, the S&P 500 has had an average annual return of approximately 9.1%. So if you factor in their average fee of (0.84%), an actively managed fund would have to generate an annual return of 9.94% in order to match the index. That’s a tall order, and one of the reasons that make index funds very attractive to the average investor.
Helping to illustrate this even more, according to the SPIVA Scorecard, the S&P 500 Index, one of the most popular index fund benchmarks, beat over 92 percent of actively managed large-cap funds over a ten-year period ending on December 31, 2016. Other index funds that focused on specific niche indices such as mid-cap or small-cap companies had an even higher winning percentage.
It’s no surprise then to know that in 2017 Americans abandoned actively managed funds to the tune of $263.8 billion.
What are the benefits of index funds?
- Automatic Diversification– Because index funds provide exposure to broad market segments, an investor’s portfolio will benefit from having some components of the index rising when other components are declining – the essence of diversification within the asset class.
- Low operating expenses– this is particularly important if you have only a small amount to invest. In those cases, commissions and fees can easily eat up a meaningful amount of principal if you were investing with a broker.
- Low portfolio turnover– index funds are buy-and-hold on steroids. By definition, index funds do not make frequent changes to their asset mix. This is another way that index funds can keep their expense ratio low.
- Predictable performance without chasing returns– if the S&P 500 Index increases by 10% in a given year, an index fund that tracks the S&P 500 will have a similar return because it is comprised of the same list of stocks and the objective of the fund is to match the return of the index. This can take the stress out of investing for investors who may not have the aptitude or interest to track different stocks.
Are there downsides to index funds?
There can be, but to understand them requires some context. Here’s an analogy that might help. If the objective of your fitness routine is to lose a few pounds, build a little muscle tone, and just get an overall better sense of well-being, then you could probably find fairly low-cost fitness equipment to help you meet your goals. You won’t get the spectacular results, and may not be able to customize your workouts, but you’ll have the right tool for the job.
In a similar way, for many investors, an index fund is the right tool for the job. They understand the importance of investing, they want to see a positive return, but don't want to take a lot of risks and don't have the expertise to pick their own stocks.
However, for other investors, index funds are not sufficient for their investment objectives. For them, index funds can have negatives including:
- Index funds don’t beat the market – Going back to our chart above, index funds are not intended to outperform an index but to match it. When the market goes down, index funds go down. That may not meet the investment objectives of some investors.
- Index funds only approximate the actual stocks the index is composed of –The proportion of each stock included in the fund might not always keep up with the proportion included in the index. Also, some companies will stay on the index (or in the fund) longer than they match the description of the index. For example, if your objective is to invest in mid-cap stocks, you may find that an index fund that is supposedly following a mid-cap index still includes companies that have outgrown any definition of “mid-cap.”
- Index funds aren’t always weighted in the way you want – this is related to index funds only approximating the market. For example, some analysts would say the S&P 500 index is weighted too heavily on financial companies. Individual investors with the knowledge of industries and sectors that produce historically higher-than-average returns may find index funds too limiting.
How to invest in an index fund
- Consider where you will be investing. If you purchase an index fund from a mutual-fund company or a brokerage, you’ll want to pay attention to things like fund selection, whether they provide all the services you may need if you are also planning on investing outside of index funds, whether they have commission-free transactions, and how much they charge to buy or sell the fund. If you are investing in your company’s 401(k) plan, you will probably have a limited selection of index funds. The question you have to consider is if the selection is too limiting? This is particularly important since there are limited opportunities to make changes to your investment choices.
- Pick an index. The S&P 500 index is very well known, but in reality, there are a number of indexes and index funds comprised of large, well-known companies representing different industries and sectors. For example, you can look at index funds based on:
- Company size and market cap – These are index funds that track large-cap, mid-cap, or small-cap companies (e.g. Vanguard Small Cap Index Fund)
- Geography – These are index funds that are traded on foreign stock exchanges or a combination of international exchanges
- Industry or Sector – These index funds focus on specific areas such as technology or health care.
- Asset Type – Asset allocation is another important investing strategy. These index funds focus on specific assets like bonds and commodities (e.g. Vanguard Total Bond Market Index)
- Market Opportunities – These index funds focus on emerging markets or other young, growing sectors. These are more speculative in nature, but investors can still get the benefits of diversification.
Although there is a dizzying array of choices, most investors only need to have one index fund in their portfolio to be well diversified.
- Read the prospectus. Reading a prospectus is important, but it can be like reading your vehicle’s owner’s manual- very few people actually do it until some need arises. A prospectus is a reference tool that you use to get answers to specific questions. With that in mind, here are a few questions that a prospectus should easily be able to answer. If you’re working with an advisor or broker, they can probably find these answers for you.
- Do the fund’s objectives match your own? How does the fund intend to make money and what risks will they take to achieve that growth?
- Is the fund’s strategy risky? For example, if you’re investing in an oil and gas index fund, how have they handled the volatility of this market in the past?
- How much will it cost you? For passive index funds, the typical ratio is close to 0.2%, although this number can vary widely depending on the fund type. Most index funds also have a minimum investment amount that could be in the thousands of dollars.
- What does the performance table look like? Past performance is not an indicator of future results, but it can give you a sense of how consistent a fund is. History doesn’t repeat itself, but it frequently rhymes.
- What are the regulations for buying and redeeming shares? Is there a minimum purchase requirement? Is there a minimum redemption amount?
The bottom line on index funds
Index funds can be an ideal choice for investors who are just getting into the market and are growing a small portfolio. Because of their low expense ratio, they will ensure that profits are not getting absorbed by administrative costs. At the same time, investors can expect predictable performance as the nature of an index fund is to generate performance that matches the index that it is tracking.
As with other mutual funds, an index fund helps take the guesswork out of choosing securities. This makes investing more accessible to a wider range of investors who might otherwise stay out of the market, be left to choose securities for themselves, or be put in a position of using a broker or advisor and see a disproportionate amount of their growing portfolio subject to administrative costs.
And there’s no doubt that index funds are growing in popularity. Even Warren Buffett has extolled the virtues of investing in index funds. But they’re not for every investor. As a portfolio grows, index funds may put a ceiling on growth that more experienced investors will find limiting.
However, for many investors index funds are the right tool to help them meet their investment objectives, and there are certainly a variety of index funds to match the many different objectives that investors have.