What Is an Index Fund and How Does it Work? (2024)

Investing

Jun 15, 2023

Index funds are attractive to new investors because they provide built-in diversification, meaning your money is spread out across many different companies. This can help reduce risk and provide a good foundation for long-term growth. Plus, index funds often have lower fees compared to other investment options, which means more of your money can go towards building your wealth.

If you think index funds might be right for your portfolio, this guide will get you started.

In this article, we’ll cover:

• How index funds work
• Pros and cons of Index Funds
• Types of index funds
• What to consider with choosing index funds

How index funds work

A market index is a measuring tool that helps people understand how the economy is doing and how different groups of investments are performing. It’s like a yardstick that measures the overall performance of certain assets, such as stocks or bonds, or even specific sectors like healthcare or an ethical stance like socially responsible investing.

Instead of trying to beat the market, an index fund aims to match the performance of one or more market indexes. It does this by buying securities, which are things like stocks or bonds, that are included in the index. Essentially, the fund tries to replicate the investment holdings of the market index it is tracking.

While you can’t directly invest in market indexes, investing in index funds is a close alternative. When you invest in an index fund, you become a shareholder and own a portion of the fund. Depending on the holdings of the fund, you might receive dividends, which are a share of the company’s profits, or interest from bonds, as well as capital gains distributions when the fund sells securities that have increased in value. But they don’t buy and sell securities frequently, index funds are typically tax efficient.

There are thousands of market indexes available today; some of the most well-known include:

• Nasdaq Composite Index
• Wilshire 5000 Total Market Index
• Dow Jones Industrial Average

It’s important to note that a stock index is not the same as a stock exchange. The index tracks the performance of a specific market, while the exchange is the actual place where stocks are bought and sold.

Understanding market indexes and their role as measuring tools can help investors make informed decisions and choose index funds that align with their investment goals.

Pros and cons of index investing

Index funds typically follow a passive investment strategy, with fund managers buying and holding stocks to maximize earnings over the long run. Market indexes are rebalanced periodically, often once a quarter or once a year, and index funds generally adjust the fund’s holdings to match. In contrast, other types of funds may employ an active strategy, which attempts to outperform the market or target some other specified outcome. This usually requires more frequent trades and adjustments to the fund’s composition.

Many investors prefer the hands-off investing strategy offered by index funds and benefit from their lower costs and consistent performance. However, it’s important to note that index funds are not designed to beat the market, so they will trail their underlying indexes most of the time. And while index funds may be useful for portfolio diversification, all investment comes with risks like market downturns and underperformance.

Advantages of index funds:

• Diversification: Because funds contain many different securities, there’s some built-in diversification. The level of diversification will vary, though, since an index fund focused on one sector may be less diverse than one that mirrors the overall stock market.
• Lower costs: Index funds usually are passively managed, which means investor costs and expense ratios tend to be lower compared to actively managed funds.
• Hands-off investing: An index fund is not an actively managed fund. Once you invest in an index fund, you can generally sit back and let the fund do its work. This low-maintenance approach is appealing to many investors who prefer a more hands-off passive investing strategy.
• Consistent performance: Index funds have historically shown consistent performance over the long term. For example, funds that track well-known indexes like the S&P 500 have a strong performance record. However, it’s important to remember that past performance is not a guarantee of future results, and index funds may not always outperform the market.
• Tax efficiency: The tax implications of investing in index funds may be a bit different compared to other types of funds. Taxes on dividends and short-term capital gains are usually the same as your income tax rate, while earnings on investments held for more than a year are subject to the lower capital gains rate. Index funds usually produce lower dividends and hold stocks for a longer period of time, which can make them more tax efficient.

Disadvantages of index funds:

• Limited upside potential: Index funds are not designed for rapid or significant growth that beats the market, and they may trail the performance of the index they aim to match.
• Lack of flexibility: Because an index fund is committed to duplicating performance, a falling index could mean shrinking returns; passive management can reduce the flexibility to respond to decreasing performance.
• No protection from market downturns: While they provide diversification benefits, index funds are still subject to market risks. If the market has a bad day or enters into a bear-ish period, chances are the index fund will reflect that negative performance.
• Underperformance due to index composition: While an index fund aims to conform to an index’s performance, there is always the risk it won’t. Performance is dependent on the composition and weighting of the underlying index, so if the index includes underperforming stocks or sectors, the index fund will suffer.
• Diversification isn’t guaranteed: While index funds invest in a variety of securities, the level of diversification can vary. If a fund is tied to a specific market sector, all of its assets may lose value if that sector experiences a downturn. It’s important to consider the diversification characteristics of the specific index fund you are investing in.

Types of index funds

If there’s a sector, asset class, or another type of investment you’re interested in, there’s likely an index that tracks it. And, more often than not, there’s a fund dedicated to mirroring the index’s performance. Here’s a look at common types of index funds you may encounter, including broad market, equity, sector-specific, international and global, bond, balanced, and socially responsible index funds.

Broad market index funds

Also called total market index funds, broad market index funds aim to replicate the performance of an entire market, such as the U.S. stock market. They generally buy thousands of different securities across multiple sectors, providing investors with broad exposure to the market and greater portfolio diversification.

Equity index funds

These funds seek to match the performance of specific stock market indexes. For instance, a fund might target the S&P 500 or the Nasdaq Composite. Some of these funds focus on a single index, while others might track multiple stock indexes. If you want to invest in the biggest and most well-known companies, these funds can help you do just that.

Sector-specific index funds

As the name implies, these index funds focus on a specific market sector. They might use a sector-specific stock index or target one category within a more general index, such as stocks in the consumer staples category of the S&P 500. So, if you’re passionate about a particular industry or believe in the potential of a specific sector, these funds can help you invest with a laser focus.

International and global index funds

These index funds allow you to invest in securities outside the U.S. by targeting the performance of another country’s index. Investing in funds connected to international indexes, like the Nikkei in Japan or the DAX in Germany, could help level out some of the volatility in your domestic portfolio. It’s like broadening your investment horizon and exploring opportunities beyond your home country.

Bond index funds

Also known as fixed-income index funds, bond index funds target bonds instead of stocks. They invest in securities like government and municipal bonds, with the goal of matching a particular bond index. If you’re looking for investments that offer more stability and regular income, bond index funds can be a good fit for your portfolio.

Balanced index funds

These index funds invest in multiple types of securities, and often include a mix of 60% stocks and 40% bonds. They usually try to match at least one stock index and one bond index. Balanced index funds offer a balanced approach to investing, combining the growth potential of stocks with the stability of bonds. It’s like having a well-rounded meal for your portfolio.

Socially responsible index funds

Socially responsible investing (SRI) index funds hold stocks in companies that aim to have positive community, environmental, or social impacts. Many SRI indexes focus on companies with high MSCI ESG ratings, which measure a company’s resilience to long-term, financially relevant ESG (environment, social, governance) risks. If you want your investments to align with your values and make a positive difference in the world, socially responsible index funds can help you invest with purpose.

Factors to consider for choosing an index fund

Like all investment strategies, what works for you depends on your financial goals. Remember that index funds are not designed for short-term investing, so choose a fund that you’re interested in for the long haul. In addition to knowing your risk tolerance and time horizon, there are several factors you should consider before choosing an index fund.

• Expense ratio: Each fund has an expense ratio, which compares the fund’s total operating expenses, including fees, with the amount of its assets. Expense ratios can help you get a sense of whether fees are likely to be higher or more moderate when comparing funds.
• Tracking error: Fund performance usually doesn’t correspond perfectly with index performance. Tracking error is when managers achieve returns above or below the index. A well-managed index fund should closely mirror the performance of the index it’s tracking, so look for one with a 1% to 2% tracking error.
• Fund size and liquidity: Index funds can track small, medium-sized, or large companies, all of which have different levels of risk and potential reward. Different funds may also have different levels of liquidity, which refers to how easily you can sell your shares and redeem them for cash.
• Investment objective and strategy: Consider which index or indexes a fund follows, the areas the fund focuses on, and the asset types available. Look for funds whose objectives and strategies align with your own investing goals.
• Historical performance: Past performance is no guarantee of future performance, but historical data can be useful. Understanding how the index has weathered past ups and downs may provide helpful context for your investment decisions.

Diversifying your portfolio with index funds

What is an index fund’s role in your portfolio? It depends on your goals. Index funds can be a useful starting place for beginners, as they make diversification easier. And if you’re focused on long-term growth, index funds may play a prominent role in your strategy. Some investors also leverage index funds as a hedge against volatility; the generally steady growth of these funds may balance out the ups and downs of more volatile stocks in your portfolio.

There are many options available that will help diversify your portfolio and start you on the road to your long-term financial goals. If you see a place for index funds in your portfolio, Stash can help you start investing in them today.