Banking » Investing » Index Funds Basics – How It Works,Types And Benefits
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Index Funds Basics – How It Works,Types And Benefits

What exactly are index fund and how does it work? what are the most popular types of and which benefits you can get by investing in an index fund?
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: January 1, 2024

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There are different types of index mutual funds in the US, and their numbers vary greatly, based on data from ICI

 

What Are Index Funds?

If you want to understand index funds, first you need to know what an index is. They are not investments themselves like stocks, gold or petrol. It's more like a concept.

Here’s the idea:

These indexes are groups of assets that represent a particular section of the market (bonds, stocks, industry, etc.) and track the performance in order to evaluate the whole sector. Therefore, an index fund is a type of mutual fund that follows and tracks the results of a market index. They “mimic” the performance of an index, and are investment tools.

Index funds can be either structured as mutual funds or exchange-traded funds.

  • Mutual funds are pools of investor's money which are used by professional management (the funds) to buy assets.
  • Exchange-traded funds just like mutual funds are a “basket” of funds but they differ in the way they trade.

Examples of some of the most well-known indexes are Dow Jones Industrial Average (DJIA), Nasdaq Composite index and the S&P 500:

Other examples: The Russel 2000 (it tracks small-cap stocks), the Russel 3000, the Wilshire 5000, The Barclays Capital Aggregate Bond Index, which is a bond index.

How Index Funds Work?

Unlike other mutual funds whose managers actively invest in assets, index funds are rather passive investment tools. They do not try to beat the index but “mimic” the performance of this index.

Let's start with an example:

An index fund Z follows the performance of the S&P 500. The managers of the fund will not try to find the best stocks out there but rather replicate the performance of the S&P 500. The fund will include only assets of the respective index in the portfolio.

Nevertheless, the type of stocks is not the only important thing. The management of the fund should decide how many shares per company to buy and invest in. Why?

Because they will try to match the percentage of “weighting” of the respective index. An index that “weighs” and gives a larger percentage to stocks with a higher market capitalization is called market cap indexes.

For example, S&P 500. So, the larger percentage a company has, the more stock of that company the fund will purchase.

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Index Funds vs ETF

Both Index funds and ETFs are indexes tracking a specific pool of portfolios, like bonds or stocks. They offer investors high diversification due to the underlying securities they usually track. They attract low costs because they are passively managed. These indexes have proven to have reliable returns, with indexes such as S&P 500 averaging 10% for the past 90 years.

A key difference between index funds and ETFs lies in how ETFs can trade throughout the day like stocks, while index funds can be traded at the price set at the close of trading. In addition, EFTs have lower minimum investment than index funds, and you may only need the amount need to buy a single share. However, index funds may have higher minimums that may be higher than a typical share price.

Index Funds vs Mutual Funds 

Index funds and mutual funds are both popular investment vehicles but they vary in their portfolio constituents – the underlying pool of securities making each investment. Index funds follow specific securities across multiple industries, while mutual funds comprise investments that are selected by an investment fund manager.

Mutual funds are actively managed, meaning the investment manager makes key investment decisions, while indexes are passively managed, and they track certain stocks and bonds. As a result, index funds have lower fees of up to 0.09%, while mutual funds attract higher fees at an average of 0.82%.

Benefits

Let’s take a look at the benefits of index funds:

Index funds are some of the most accessible investments. If you know which indexes are good and which are bad, then you can find the best mutual fund to invest your money.

The cool thing is they give you the chance to invest in a whole segment of the economy without having to pay a lot or spend time.

These types of funds are managed passively. The person who is in charge of the management will invest only in assets that are represented in the respective index. The purpose is to reflect the index as much as possible. That minimizes the risk of bad decisions by the fund's manager.

The passive management keeps the turnover low which helps minimize taxes on investments. Nevertheless, you will have to pay taxes on capital gains and dividends if you keep them in a taxable account.

Even though there are different types of index funds depending on the fund company, index funds are generally cheaper. Since they are passively managed, costs and fees are lower than the other types of mutual funds.

Let’s not forget:

You should be careful when picking the right index fund since the fees and charges associated with them can vary. Some boast an expense ratio of 0.16% (which is basically nothing). Others, on the other hand, can skin you with 1.5o% expense ratio. Particularly expensive are those tracking the S&P 500.

This is one of the most important benefits. Indexes track a wide range of assets representing a segment of the market. Therefore, participating in an index fund you can expect to have a broad diversification.

Here’s the thing:

Usually, index funds invest in hundreds or thousands of holdings. In comparison, other mutual funds invest in 50 or even fewer.  This broader exposure mitigates the risks related to investing just one poorly performing sector. The more you have in your portfolio, the less the risk.

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Drawbacks

Here are the most important cons you should consider before investing your money in index funds:

Index fund managers have less flexibility than managed funds because they must adhere to policies and strategies that require them to attempt to perform in lockstep with an index. Index fund investment decisions must be made within the constraints of matching index returns.

For example, if an index's returns are rapidly declining, index fund managers have few options for limiting their losses. Managers of actively managed funds, on the other hand, have more leeway to act in order to find better-performing alternatives in both good and bad times.

Index investing does not permit profitable behavior. When a stock becomes overvalued, it begins to carry more weight in the index. Unfortunately, this is precisely the time when astute investors would want to reduce their portfolio's exposure to that stock.

So, even if you have a good idea whether a stock is overpriced or underpriced, if you only invest through an index, you won't be able to act on that knowledge.

The passive management keeps the turnover low which helps minimize taxes on investments. Nevertheless, you will have to pay taxes on capital gains and dividends if you keep them in a taxable account.

Index funds do not have the potential to outperform the market in the same way that managed funds do. This means that investing in an index fund means foregoing the possibility of a massive gain. The top-performing non-index funds outperform the top-performing index funds in a given year, and the very best non-index funds can outperform an index fund in a given year.

The top-performing non-index funds, on the other hand, may vary from year to year, so that under-performing years can cancel out out-performing ones, whereas index funds' performance remains more consistent.

The Best Ways of Investing in S&P 500 Index Funds

The S&P 500 index funds provide a high return over time and low-risk ways to invest in stocks. S&P 500 index funds boast some of the lowest expense ratios in the market and are generally cheap compared to other investing options. Here are our top 3 S&P 500 funds:

  • Vanguard S&P 500 ETF – VoO: It's one of the most important funds on the market, with hundreds of billions of dollars in the fund. Vanguard, one the most powerful fund companies in the world, has supported this ETF since it began trading in 2010.
  • iShares Core S&P 500 ETF – IVV: BlackRock, one of the world's largest fund companies sponsors the iShares Core S&P500 ETF.  This fund, which was established in 2000, is another long-standing player that has closely followed the index over time.
  • Schwab S&P 500 Index Fund SWPPX: The S&P 500 Index Fund by Schwab aims to track the total return on the S&P 500 Index. The fund typically invests at least 80 percent of its net assets. The fund will generally seek to replicate the index's performance by assigning the same weight to each stock as the index.

Index Funds Vs. Actively Managed Funds

There is a great deal of difference between index funds and other mutual funds. Index funds as already discussed are passively managed – they track a major index. The managers of an index simply replicate the performance of the index without the assistance of analysts or any other people who might research the market for the best options.

On the other hand, actively-managed funds are managed by a portfolio manager who is responsible for handpicking investments. The portfolio manager must analyze multiple investment options to pick investments that will outperform the market index. As a result, actively-managed funds have the potential to outperform index funds, which makes it more attractive to investors.

Therefore, the management expense ratio is lower than funds who are actively managed. It's hard to beat well-performing indexes, therefore usually index funds outperform other mutual funds. You can include index funds in your retirement accounts, for instance.

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What is the S&P 500 Index? What should new investors learn about it?

The S&P 500 generally includes the 500 largest publicly traded US companies according to market capitalization. These firms must be located in the US and have publicly traded shares that are available for everyone to buy or sell. They also need to be profitable within the last year. The 500 members together account for approximately 80% of all publicly traded stock in the United States. The performance of the US stock markets is often represented by the S&P 500.

Many new investors don't want to choose their stocks and prefer to invest in the US stock exchange. You can purchase shares in a mutual fund, or ETF to achieve this. On the other hand, if you may prefer to invest in specific stocks, comparing your portfolio's performance with the S&P 500 will help you determine if your portfolio is underperforming or outperforming the market.

Investment in an S&P Index fund is a great way for you to diversify your portfolio and reap the benefits of the awesome returns offered by the S&P 500. The S&P 500 is great for new investors as well, even if they want to invest with a more hands-off approach.

How Do You Invest in S&P 500 Index?

The S&P 500 is not a stock that you can directly invest in. It's a stock index or group of stocks . Over the years, index funds that track an underlying market index are becoming more popular with new investors. An index fund could track the performance of the S&P 500, allowing investors the opportunity to own all the holdings in those indices. There are index funds that track Standard & Poor’s 500 Index. Index funds can provide investors broad market exposure, or exposure to a specific sector.

Index funds are typically “passively managed” which means that the investment professionals who oversee them don't trade their holdings much. They aim to replicate the index's performance and make it better than trying to beat it. Long-term, buy-and hold investors who are looking to grow their wealth on autopilot will love index funds.

Final Words

Overall, index funds are a good start to begin your trading career. They are easy to use and accessible as well as well regulated. They are efficient when it comes to fees and costs and also give you great portfolio diversification. It's particularly suitable for budding investors who don't have unlimited resources.

Index funds are also a good way to make money so that you can start investing in the underlying assets at a later stage. If Warren Buffet recommends it, then it's worth trying.

FAQs

The answer is yes. However, it depends on the type of index fund security you are holding. For example, bond index funds typically pay dividends per month while stock index funds, like the Standard & Poor's 500 Index, pay dividends annually or quarterly.

Indexes tracking large companies, like Fidelity Blue Chip Growth Fund (FBGRX), which have financial stability, typically pay quarterly. If you invest in indexes tracking growth stocks with little to no dividends, they often pay annually.    

Generally, the average return you can earn depends on the index you have invested in. With over 5000 U.S. indexes, investors can expect to earn varying levels of returns.

However, the S&P 500 index is the most popular US index, and it has a reputation of having an average return of 10-11% based on an analysis conducted from 1926 to 2018. When looking for the best index to invest in, you should consider expenses, taxes, and investment minimums as your top 3-items for evaluation.

The chances of losing your money through index funds depend on your investment decisions. Generally, if you make poor choices, you will lose your investment. But if you are savvy in market analysis, doing your fundamental and technical evaluations with a high degree of accuracy, you can always mitigate losses.

Besides these skills, the type of trading account can determine the magnitude of your risks. For example, with a marginal account, your risks are unlimited. But with a cash account, the risk cannot extend beyond the amount of investment.

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Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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