Stock indexes like the S&P 500 and the Nasdaq Composite are large, weighted collections of stocks used by investors to track the performance of the equity market at large. Because the stock market tends to go up in value in the long term, many passive investors seek to invest in the market (or some segment of it) in general. Unfortunately, stock indexes aren’t investable—that’s where index funds come in.
What Are Index Funds and How Do They Work?
Index funds are pooled investment vehicles (they can be mutual funds or ETFs) that are designed to mirror the performance of a particular stock index. Each index fund’s aim is to match the composition and weighting of a target stock index as closely as possible in order to produce approximately the same returns as the index itself.
For example, The Vanguard Russel 2000 ETF is composed of the same stocks in roughly the same percentages as the Russel 2000 stock market index, which tracks the lower-market-cap portion of the U.S. equity market. Investors interested in this market segment can buy shares of this ETF if they want their portfolio returns to match those of the Russel 2000.
The manager of an index fund may need to rebalance the fund’s holdings from time to time to ensure they closely match the weighting of the targeted index. For instance, many popular stock indexes are weighted by market capitalization, such that companies with larger market caps are more heavily weighted. Thus, if a particular company’s market cap increases significantly, its weighting in a stock index may increase proportionally, and the manager of an index fund that tracks that index would have to increase the funds’ holdings of that stock to match its new weighting in the target index.
What Are Index Funds Good For?
Index funds are popular among investors because they are one of the easiest channels through which to build a diversified portfolio with a single investment. The Vanguard Russel 2000 ETF mentioned above, for instance, holds 2000 different stocks, exposure to which can be gained by buying a single share of the fund.
By dollar-cost averaging (investing the same amount periodically regardless of performance) into one or more index funds over a period of many years, an investor can build a well-diversified portfolio with very little effort.
And while the stock market is notoriously volatile—especially during bear markets, recessions, and inflationary periods—equities have historically outperformed other asset classes in the long term. For this reason, a passive investing program that includes index funds can be an easy, hands-off wealth-building strategy for investors with longer time horizons (e.g., those who plan to stay invested until retirement or for 10+ years).
Index Funds vs. Actively Managed Funds: What Are the Differences?
Many mutual funds (and some ETFs) are actively managed, meaning their fund managers use research and analysis to pick stocks and time trades with the goal of “beating the market” or producing returns higher than those of a benchmark stock index like the S&P 500.
Index funds, on the other hand, are passively managed, meaning their composition is pegged to that of a target stock index with the aim of matching the returns of that index.
While active, stock-picking strategies can outperform the market sometimes, they are also riskier than the passive-investment strategy offered by index funds, and they may be just as likely to underperform the market as to beat it.
For this reason, many passive investors—like those who contribute to an IRA or 401(k) with the goal of slow and steady gains—invest in index funds as part of a hands-off approach to saving for retirement or building wealth.
Additionally, since the managers of index funds don’t need to perform analysis, watch the market, or buy and sell stocks outside of rebalancing efforts (which are often conducted automatically by a computer program), index funds tend to have significantly lower fees than actively managed funds.
Index Mutual Funds vs. Index ETFs: What Are the Differences?
When index funds first became available in the late 1970s, they were all mutual funds. In the modern day, index ETFs are also available, and investors are free to choose whichever fund type best suits their needs.
For most retail investors, index ETFs are preferable to index mutual funds for several reasons.
Fees
First, ETFs only charge one fee—an expense ratio. This fee is a percentage of the investor’s total investment charged annually to cover the expenses of the fund’s management. Index mutual funds also charge expense ratios, but they may tack on other fees—like front and back-end loads—as well.
Investment Minimums
Many mutual funds have minimum investment thresholds (e.g., $2,500), which can be an entry barrier for investors that don’t have a lot of cash on hand. ETFs, on the other hand, trade on exchanges and are sold in shares just like normal stocks, so they can be purchased easily, especially on trading platforms that allow investors to purchase fractional shares like Robinhood and Fidelity.
Liquidity
While liquidity isn’t as important a consideration for long-term, buy-and-hold investors (the primary audience of index funds), it is worth noting that ETFs are more liquid than mutual funds, as they can be bought and sold throughout trading hours just like stocks. Mutual fund shares, on the other hand, can only be traded once per day at the end of each trading session, which means all trades executed on a given day occur at the same share price.
For shorter-term traders interested in index funds, index ETFs are certainly preferable to index mutual funds.
Advantages and Disadvantages of Index Funds
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors ask about index funds.
Do Index Funds Pay Dividends?
If the stocks held by an index fund pay dividends, the fund must pass those dividends on to shareholders. Since index funds usually hold hundreds or thousands of stocks, virtually all of them pay dividends.
What Is Tracking Error?
When it comes to index funds, tracking error refers to any difference between the performance (returns) of an index fund and the performance of its benchmark stock index. Tracking error in index funds is usually the result of delays or inaccuracies in rebalancing efforts.
What Was the First Index Fund?
Jack Bogle, founder of the Vanguard Group, created the Vanguard 500 index fund in 1976. The fund, which still exists, holds 500 of the largest American stocks by market cap, and its early success surprised many finance industry professionals, who had initially dubbed the project “Bogle’s folly.”
