What Is an Index Fund?

January 28th, 2020

 

The quick and dirty: Index funds are a low cost way to invest your money that mimics the performance of the stock market or a particular segment of the market.

 
Want the longer explanation? Then read on! Or if you’re looking for a big picture investing overview, you can start with our Investing Cheat Sheet.
 

Investing in the stock market

Investing is a great way to passively grow your wealth over time. But when you invest in the stock market, you’ll have a wide range of potential investments to choose from – literally thousands of potential investments. So you’ll need a strategy.
 
One approach would be to buy individual stocks, like Apple, Microsoft, Coca-Cola, Tesla, Netflix (ie any company that’s publicly traded), and build your portfolio that way.
 
At first glance, this might seem like a good idea. Hey, you know which companies will be hot right? You can pick the winners, sit back, and watch the profits roll in.
 
But in reality, creating and maintaining an investment portfolio like this takes a lot of time and energy (and picking those winners is a much harder than it looks).
 
So for most people, a better strategy is to invest in funds. With a fund, your money will be pooled along with other investors and spread across multiple investments.
 
This means your money will be diversified (spread out). And you won’t have to deal with the hassle of buying and selling individual stocks.
 

Actively managed vs passively managed funds

There are two basic approaches to managing investment funds: active and passive.
 

Actively Managed Funds

With actively managed funds, a professional money manager, or team of professionals, will actively pick and choose which investments to hold in the fund. Their goal is to buy stocks that will outperform the broad market and avoid stocks that will under perform it.
 
Sounds like a good strategy right? Well, maybe, but maybe not. Research has actually shown that on average, active managers don’t outperform the broad stock market (even professionals have a hard time picking those winners). This is especially true once you’ve accounted for the fees they charge, which tend to range from about 0.5% to 1% per year. And while some managers are able to beat the market, it can be difficult to identify those managers in advance.
 

Passively Managed Funds

With passively managed funds, there is no manager trying to “beat the market”. Instead, the fund is designed to represent the market as a whole or a certain sub-segment of the market. Typically this is done by having the fund mimic a stock index.
 
A stock index, like the S&P 500, is designed to measure the performance of the stock market or a specific segment of the market. Think of creating a basket of stocks, and seeing how their collective prices change over time. That’s what an index is.
 
The three most well-known indices (plural of index) are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite. They each represent a slightly different cross section of the market and are often reported in the financial media to track the performance of the market.
 
Since passively managed funds tend to track a specific index, they’re referred to as index funds.

 

Why have index funds become so popular?

Index funds get a lot of attention these days. And they’ve actually surpassed actively managed funds in terms of total dollars invested. Their success mostly comes down to fees.
 
Index funds are usually much less expensive than actively managed funds.
 
While actively managed funds typically charge about 0.5% to 1% per year in management fees, index fund fees tend to be closer to 0.1% or even less. This difference may seem small, but it can add up to serious money over years of investing. And if actively managed funds don’t actually outperform the market, then it’s hard to justify paying their higher fees.
 

So are index funds right for me?

Well, we aren’t here to recommend specific investments. But it’s tough to ignore the convenience and cost savings of index funds. Not to mention, there’s a wide range of index funds to choose from these days – covering different countries, different industries, different sized companies (large vs small), and more.
 
But keep in mind, you don’t need to be invested entirely in index funds or entirely in actively managed funds. Some people prefer a combination of both.
 
When it comes down to it, there are a lot of ways to build a sensible investment portfolio that will meet your needs. If you’re looking to get started, we have your back.
 

Anything else we can help you with?

► Learn How to Start Investing on a Budget

► Find a New Savings Account (and possibly earn higher interest!)

► Learn How to Open an IRA Account
 

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