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Mar 15, 2022

What Is an Index Fund and How Does it Work?

By Stash Team
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You’ve probably heard of market indexes like the Dow Jones Industrial Average or S&P 500. These indexes can help you understand the economy at large. You can’t invest in them directly, but you can invest in an index fund that aims to mimic the way they perform. These funds may offer more diversification, lower costs, and lower risks than some other securities. If you think index funds might be right for your portfolio, this guide will get you going with index investing.

What is an index fund?

An index fund is a mutual fund or exchange-traded fund (ETF) that strives to match the performance of a market index.
A market index is a measuring tool that helps people understand a group of related securities: an asset class like stocks or bonds, a sector of the market like healthcare, an ethical stance like socially responsible investing, and so on. There are hundreds of market indexes available today. A well-known example is the S&P 500, intended to depict the general performance of the U.S. stock market overall, which is composed of 500 large US stocks.

How index funds work

You can’t invest in market indexes directly; that’s where funds come in. An index fund is a mutual fund or exchange-traded fund (ETF) that buys securities in an attempt to match the performance of one or more indexes. You buy shares of the fund through a brokerage and reap the rewards if the shares increase in value. And depending on the fund’s holdings, you might receive dividends, interest, and capital gains distributions. Keep in mind, however, that all investing involves risk, including possible loss of principal, and if the shares of the index fund decrease in value, you may lose money.

How are index funds managed?

Index funds typically follow a passive investment strategy: fund managers buy and hold stocks to maximize earnings over the long run. In contrast, other types of funds may employ an active strategy, which attempts to outperform the market or target some other specified outcome, and usually requires more frequent trades.

How do index funds mirror index performance?

There are two common ways to replicate an index’s performance: invest in all the securities that make up the index or pinpoint a subset of them. 

Fund performance usually doesn’t correspond perfectly with index performance. Tracking error, when managers achieve returns above or below the index, is inevitable. Index funds often have a 1% to 2% tracking error.

What is index weighting?

Index weighting determines how much each company’s performance influences the index, which can have an impact on index fund returns too. 

  • In a price-weighted index, the higher a company’s share price, the more effect it has. This makes for more volatility, and funds typically need to to buy and sell shares often. That could mean higher fees for investors.
  • In a market-cap-weighted index, the higher a company’s market capitalization, the more effect it has. They are less volatile day-to-day and likely to have lower fees. But the largest assets’ performance can have an outsized impact on returns. 

An equal-weight index gives the same weight to every company, no matter what its share price or market cap is. That can reduce the risk that a single holding will crash the index, but also can remove the possibility that a superstar might drive it up.

Fees, costs, and expense ratios

Index funds’ passive management approach often makes them less expensive than actively managed funds. But it’s likely you’ll still pay fund costs in addition to brokerage charges.

  • Mutual index funds often have management fees, plus load fees for buying and selling shares. They may also have 12b-1 fees, which are up to one percent of your assets. 
  • Index ETFs do not have 12b-1 or load fees, but may have other costs. 

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. 

Tip: Not every index fund has lower fees than an actively managed fund, so it’s a good idea to read the fine print. This calculator can help you compare the costs of funds.

Average rate of return

Just like with any other type of investment, you’ll likely want to figure out how much money you’re earning with an index fund. Average rate of return measures how much you made or lost on an investment. Here’s how it works:

  • To find out how much you gained or lost during a certain time period, calculate the total amount of your return. Simply add the investment’s change in value (up or down) to any income, like interest or dividends, that you may have earned.

For example, imagine you spent $100 to buy 10 shares in an index fund that cost $10 apiece. After three years, the share price is $11. You’ve also earned $2 in dividends. Your total return would be $12: the present value of the shares, minus what you paid for them, plus the dividends.

((10 x $11) – (10 x $10)) + $2 = $12

  • Once you know your total return, you can calculate your average rate of return, which is expressed as a percentage. Divide your total return by your initial investment, then multiply by 100 to get a percentage. 

Using the example above, your imaginary investment had a total return of $12 and an initial cost of $100. Thus, it earned a 12% rate of return.

($12 / $100) x 100 = 12%

Tip: When you’re calculating your average rate of return, make sure to add any fees you paid to the amount you invested. And when you add up what you’ve earned or lost, deduct any taxes you paid.

Types of index funds

If there’s a sector, asset class, or other 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:

  • Broad market index funds aim to replicate the performance of an entire market, such as the US stock market. They generally buy thousands of different securities across multiple sectors. These are also called total market index funds. 
  • Equity index funds seek to match the performance of specific stock 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. 
  • Bond index funds target bonds instead of stocks. Also known as fixed-income index funds, they invest in securities like government and municipal bonds, with the goal of matching a particular bond index. 
  • Balanced index funds invest in multiple types of securities; often they include a mix of 60% stocks and 40% bonds. They usually have at least two indexes they try to match: a stock index and a bond index. 
  • Sector 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.
  • Dividend index funds invest only in stocks from a particular index that pay dividends. These funds might focus on either the dividend yield or payment rate.
  • International index funds invest in securities outside the US, targeting the performance of another country’s index, like the Nikkei in Japan or the DAX in Germany. 
  • Socially responsible investing (SRI) index funds invest in the stocks of 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.

Index funds vs. ETFs

Index funds and ETFs aren’t necessarily different things. Rather, an index fund can be a type of ETF. In fact, most ETFs are actually index-based

Think of it this way: an ETF could be a passively managed fund that aims to match the performance of an index; hence, an index fund. Or it might be actively managed to pursue a particular objective, which may include outperforming the market. 

The same idea applies to mutual funds: Some of them are passively managed index funds.

Advantages of index funds

  • Potentially lower costs: Index funds usually are passively managed, which means investor costs tend to be lower compared to actively managed funds.
  • Potentially lower risk: Index funds typically use lower-risk strategies and, like all funds, they contain a “basket” of securities, which can increase your diversification.
  • Slow and steady returns: Index funds may help your portfolio grow over the long term. Funds that track the S&P 500, for example, have historically had a strong performance record over time.1 Of course, all investment involves risk, including the risk that you could lose money, and past performance is not a guarantee of future results.
  • Diversification: Because funds contain many different securities, there’s some built-in diversification. The level of diversification varies, though; an index fund focused on one sector may be less diverse than one that mirrors the overall stock market.

Disadvantages of index funds

  • 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.
  • Underperformance: While an index fund aims to conform to an index’s performance, there is always the risk it won’t. Common reasons for underperformance are tracking error, expenses, and trading fees.
  • Less opportunity for big wins: Slow and steady performance can insulate you from market dips, but it also means you probably won’t cash in on market spikes either.

Should you invest in an index fund?

The famous investing expert Warren Buffet is a proponent of index funds, but, like all investment strategies, what works for you depends on your goals. For example, if you have a moderate risk profile and you’re saving for a distant retirement, you might find the potential for lower risk, lower cost, and slow, steady growth attractive. Index funds can also be appealing choices for retirees seeking to avoid excessive risk. On the other hand, if you have an aggressive investing strategy and are willing to take on more risk for the chance of a higher return, you might find index funds too inflexible to meet your needs.
Before buying shares of any fund, it’s a good idea to do your homework. While index funds in general can have lower costs and risk, individual funds vary. For example, you might review details of a fund’s investment strategy, fund composition, and expense ratio.

How to invest in index funds

There are a great many index funds out there, so if you see a place for them in your portfolio, you can buy shares through an online brokerage or investing app. Stash offers many options, and with fractional shares, you can start today with as little as $5.

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