What the heck is…an Index Fund?

Stocks, bonds, mutual funds, index funds…you can put your money in a lot of different investments. Index funds are one of the easiest and least expensive ways to invest your money. They are so simple and have such a good track record that Warren Buffett, one of the most successful investors in the world, recommends them as the best investment for his heirs. If you want to understand the index fund, you need to start with understanding the market index.

What is an Index?

Before you can understand the index fund, you have to understand what a market index is. A market index combines the value of the entire group of investments and expresses it as one number. The most common stock market indices are:

  • The Dow Jones Industrial Average is the composite value of 30 of the largest publically owned companies in the US.
  • The Standard & Poor’s 500 Stock Index, or S&P 500, is made up of 500 of the most widely traded stocks in the US, representing about 70% of the total stock market.
  • The Nasdaq Composite Index reflects the value of all companies listed on the Nasdaq exchange.
  • The Wiltshire 5000 includes almost every publicly traded company in the US.
  • The Russell 2000 is an index of smaller publicly traded companies, so reflects the performance of smaller companies in the stock market.

As the prices of individual stocks fluctuate, it causes indices to fluctuate as well. The impact of the price fluctuation varies according to how the index is calculated (they aren’t all the same). Regardless, the bigger the company, the more changes in their stock price affects the value of the indices it is in.

What is an Index Fund?

Index funds take a market index and build their portfolio so that it mirrors the holdings and performance of that index. If the index goes up, the value of the index fund goes up. If the index goes down, the value of the fund goes down. An index fund is a variation of the mutual fund. Unlike traditional mutual funds, the index fund’s management teams is not trying to pick investment winners. That’s probably a good thing, as in many years less than 20% of actively managed mutual funds beat the overall market return.

An index fund is a passive investment. The job of index fund managers is to mimic the index, which requires less trading and generates lower costs than traditional mutual funds. And index funds generally pass these lower costs on to the investor: while many mutual funds have expense ratios over 1%, index funds are rarely over 0.4% and are usually lower. Due to the strategy employed and the low costs, investors in index funds will get very close to matching market returns.

How Do you Buy an Index Fund?

You can invest in an index fund directly through a company that runs index funds, like Vanguard, Fidelity or T Rowe Price. Or you can purchase index funds through a brokerage, either directly or through an Exchange Traded Fund (ETF).

Investing directly with the company that runs the index fund usually has lower transaction costs. Transaction costs are particularly important if you are buying in smaller installments. Buying through a brokerage is more expensive, particularly if you are going to make multiple purchases over time. Investors with more varied holdings may find that the simplicity of having all of their investments in one place makes up for the added costs. When buying through a brokerage, consider larger, less frequent purchases.

How Do I Choose an Index Fund?

There are numerous indexes that funds follow, and multiple funds following the same index. For this reason, some research should be done before deciding on a particular index fund. Morningstar gives some basic steps for researching index funds:

  • Know which index you are following: The index you are following will determine what the holdings are, and how much they are weighted.
  • Know your options: Want to invest the S&P 500? There are index funds for that. Want to invest in socially-conscious companies? There are index funds for that. Want to invest in bonds? Yes. Dividend stocks? Yes. International stocks? Yes. Vanguard alone has over 60 different index funds, so you can invest in a wide variety of funds. But the return for a Small-Cap Growth Index Fund might be very different from a Small-Cap Value Index Fund.
  • Know the tax effects: Some index funds are very tax efficient, while others will leave you vulnerable to taxes on capital gains or dividends. If you have an index fund with high tax exposure, it might be a better candidate for an IRA or other tax-sheltered account.
  • Know the cost: While index funds are known for having low fees, some are lower than others. Again, look at Vanguard, which is known for low fees. The range of expense ratios listed was between .05% for the 500 Index Admiral Shares (VFIAX) to 0.37% for the FTSE All-World ex-US Small-Cap Index (VFSVX).

Conclusion

There’s a reason index funds are popular investment tools. The concept of passive investing has generated good returns at low costs since Jack Bogle created the Vanguard 500 Index Fund in 1976. Today’s investors have a wealth of choices to wade through but can continue to find good value by investing in index funds.

This article is for information purposes only. Past performance does not determine future performance, and an investor interested in index funds should proceed with caution and do lots of research before putting their money in any investment.

Image courtesy of ddpavumba at FreeDigitalPhotos.net

References and Further Reading

60-Second Guides: Index Investing-From Fool.com

Five Reasons Your Mutual Fund Probably Underperforms The Market-from Forbes

How to Get Started Investing in Index Funds-from the Simple Dollar

Index Investing & The Lowdown On Index Funds -from Investopedia

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