Investing in index funds has become increasingly popular due to their low cost, portfolio diversification, performance, and they are easy to buy. Many people are familiar with index funds, but there may be some facts about them which surprise you.

What Are Index Funds?

An index fund is a portfolio of stocks which mirrors a market index. A popular index is the S&P 500 index which tracks 500 of the leading publicly traded companies in the United States. Rather than trying to beat the market by selecting individual stocks, these funds own all stocks constituting the index. The performance of the index fund will match the performance of the underlying benchmark.

An index fund can be either an exchange-traded fund (ETF) or a mutual fund, but it’s often used synonymously with ETF since so many ETF’s are set up as index funds.

Passive Vs. Active Investing

Index funds are a form of passive investing, meaning the fund managers are not trying to outperform a benchmark. Instead, they are holding securities which match an index and therefore the portfolio performance will mirror the market performance. If you don’t believe that a portfolio manager can find enough opportunities in the market to increase the performance of a fund above the market return, then you believe in passive investing. However, if you believe the portfolio manager would be able to consistently find opportunties to invest in companies which outperform the market, then you would believe in the value of active investing.

More recently there have been “active index funds” created. They follow an index to a large degree, but they also allow the fund manager to deviate from strictly following the index. The fund manager is allowed to choose to buy or sell certain other individual stocks that don’t reflect the make up of the index. Active index funds will have have higher fees to reflect the more active management of the investments and they will have greater risk due to the uncertainty of the performance of the additional investment decisions.

Investment Management Fees

A big advantage of an index fund is low fees because the portfolio manager is not actively searching for opportunities to outperform the market. The fund manager is paid a lower management fee because they are doing less work with an index fund. Lower fees help with the fund performance because the return earned by the fund is reduced by the fees paid to the portfolio manager. The lower the portfolio manager’s fees are, the more money the investors get to keep. Typically index funds have extremely low fees. The average is 0.2% for passive index funds and the average for an actively managed mutual fund is between 0.5% and 1.0%. There are plenty of index funds with even lower fees. At Vanguard the averge index fund fee is 0.06%.

Diversification in Index Funds

An advantage of an index fund is a reduction of investment risk through diversifcation. Up to 90% of active fund managers underperform when compared to their benchmark index. If it’s that hard to pick the winners for the professionals, imagine how hard it is for individual investors. An index fund provides you with a diversified portfolio of stocks that, as a group, usually do well over time.

Index Funds Performance

The greatest advantage index funds have offered over the last few years is their ability to capture the returns of the longest bull run in stock market history. Over the last 10 years, the SPDR S&P 500 ETF Trust (ticker: SPY), an exchange-traded fund that mimics the S&P 500 index, has enjoyed an average annual return of 11.04%. This is a great return for very little effort and better than many individual investors have been able to achieve.

The performance of passive index funds has led to a large increase in assets for index funds. According to Morningstar, in 2019 investors withdrew a net total of $204.1 billion from actively managed U.S. stock funds, while passively managed funds saw investors pour in $162.7 billion. This was the culmination of a years-long trend, marking the first time in history that the total assets of passive funds surpassed those of active funds. The in-flows to passive index funds are also due to the increase in index funds as an investment option within many 401(k) retirement plans.

Concerns About Index Funds

Index funds are a wonderful investment for many individuals, but they also have some negative characteristics. Index portfolio managers typically can’t deviate from the index holdings, even to take advantage of trends or market mispricings. They can’t exclude holding which are over-valued, even if the the general conscensus is that it’s not the best investment. One of the advantages of an index fund is diversification, but an investor may not be achieving the diversificaiton they think they are. For example, the top 5 companies in the S&P 500 are all tech companies right now and they make up about a quarter of the index my market capitalization weight. That’s a lot of eggs in the tech basket should anything happen negative happen to the tech industry.

Information to Know Before You Invest

Before you invest in an index fund be sure the read the fund’s prospectus to make sure you understand what index the fund follows, how closely the fund follows the index, and the fund’s fees and expense ratio. There are many different indexes and some funds even use a blend of indices.

Although index funds are readily available and easy to invest in, they are best for investors who are looking to leave their money invested for a long time. While the market historically rises over time, you need to be able to ride out the inevitable market ups and downs over the shorter term without it causing you to lose sleep.

As always, if you would like more information on this topic, please contact me.

Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.