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Index Funds | Definition & How to Invest | Beginner’s Guide

Index Funds Explained: Definition & How to Invest
Diana
Paluteder
4 weeks ago
19 mins read

This guide will examine index funds and the passive investment strategy of index fund investing. We will investigate what indexes and the funds that follow them are and present a step-by-step guide to investing in them as well as the possible limitations to consider when utilizing this method.

Index definition

An index is a process of tracking the performance of a group of assets using a standardized metric. These could be broad-based indices that capture the entire market, such as the Standard & Poor’s 500 Index (S&P 500), Dow Jones Industrial Average (DJIA), or more specialized indexes that track a particular industry or segment. 

Indexes often function as benchmarks against which to gauge the performance of a portfolio’s returns. One popular investment strategy, known as indexing, is to replicate such an index passively rather than trying to outperform it. By mimicking the profile of the index, either the stock market as a whole or a broad segment of it, the fund will match its performance as well. 

Note: It’s not possible to invest directly in a specific market index but instead in an index fund that tracks it. 

Index fund definition 

Index funds are a type of mutual fund or exchange-traded fund (ETF) whose portfolio mirrors a financial market index, like the S&P 500. Yet, instead of outperforming the stock market index, the fund uses it as a benchmark and aims to replicate its performance as closely as possible.

Investors can expect broad diversification and overall risk reduction through extensive exposure to hundreds of securities in a single fund, relatively low operating expenses, and low portfolio turnover by investing in an index fund. 

Index funds are passively managed, meaning they tend to hold only what’s in the index, resulting in a lower expense ratio than actively managed funds. Subsequently, investors can expect lower investment management fees with equal rates of return.

Due to high diversification and book value considerations, an index fund investor could seldom experience a total loss. As such, index funds are considered a relatively safe investment compared to individual stocks.

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Index investing 

Index investing, also known as indexing, is an effective method to manage risk and reap consistent returns. While you may be able to beat the market (a return that exceeds the industry standard), with trading costs, taxes, and human emotion and biases working against you, you’re more likely to do so through luck than skill. 

The S&P 500, on the other hand, has yielded results that have consistently outperformed the market for decades, and if you can merely match the benchmark by investing in an index fund that tracks it, you should be doing better than most investors. 

Legendary investor Warren Buffett, too, has recommended index funds as a haven for retirement savings. Instead of picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy into all of the S&P 500 companies at a low cost.

Due to a passive approach, index funds usually have lower management costs and expense ratios than actively managed funds. In addition, the simplicity of tracking the market without a portfolio manager allows providers to maintain reasonable fees. Moreover, index funds are typically more tax-efficient than active funds because they make less frequent trades.

Crucially, index investing is a valuable strategy for diversifying against risks since an index fund comprises a broad basket of securities rather than a few assets. As a result, minimizing unsystematic risk related to a specific company or industry without decreasing expected returns.

For most index investors, the S&P 500 is the most common benchmark to assess performance against, as it measures the health of the U.S. economy. Other widely followed index funds mirror the performance of the Dow Jones Industrial Average (DJIA) and the corporate bond sector. 

Passive vs. active investing strategies

Investing in an index fund is a type of passive investing wherein the holdings mirror the securities of a particular index. The opposite strategy is active investing, whereby a fund portfolio manager is actively stock picking and market timing to defeat the benchmark. 

Index fund costs

The lower management expense ratio is one primary advantage that index funds have over their actively managed counterparts. A fund’s (management’s) expense ratio includes operating costs such as compensation to advisors and managers, transaction and accounting fees, and taxes.

Since index fund managers are merely replicating the performance of a benchmark index, they don’t require the services of research analysts and others professionals who assist in stock selection. As a result, index fund managers trade holdings not as often, incurring lower transaction costs and commissions. Conversely, actively managed funds have more sizeable staffs and run more transactions, driving up the prices. 

The extra expenses of fund management are reflected in the fund’s expense ratio, get passed on to investors, and directly impact a fund’s overall performance. With their often-higher expense ratios, actively managed funds are automatically at a disadvantage to index funds and struggle to match industry benchmarks in terms of overall return.

While less expensive than other funds, it’s crucial to bear in mind that index funds can still incur the following costs:

  • Investment minimum: the required minimum to invest in a mutual fund can run as high as a few thousand dollars. That’s why it’s crucial to ensure your favorites align with the initial amount you have to invest and that you’ll be able to buy more shares in intervals that work with your budget;
  • Expense ratio: one of the main costs of an index fund. Expense ratios are subtracted from each fund shareholder’s returns as a percentage of their overall investment. Cheap index funds can often cost less than 1 percent, 0.2% to 0.5% is typical, with some companies offering even lower expense ratios of 0.05% or less. In contrast to the much higher fees that actively managed funds command, generally 1% to 2.5%;
  • Tax-cost ratio: owning the fund may trigger capital gains taxes if held outside tax-advantaged accounts like a 401(k) or an IRA.

Index fund returns 

Indexing seeks to reflect the risk and return of the overall market on the hypothesis that the market will outperform any stock picker over the long term. Indeed, most mutual funds fail to surpass their benchmark or broad stock market indexes.

For example, according to SPIVA Scorecard data from S&P Dow Jones Indices, in the five years from 2016-to 2021, about 74% of large-cap U.S. funds generated a return less than the S&P 500. Within ten years, that figure goes up to 83%.

Percentage of large-cap funds that underperformed the S&P 500. Source: Spglobal.com

Certainly, passive managing can lead to profitable returns over the long term. However, active mutual funds can perform better in other categories and shorter periods. For instance, the SPIVA Scorecard also reveals that in one year, only approximately 62% of mid-cap mutual funds underperformed the S&P 500, meaning roughly two-fifths of them beat it in the short term. 

SPIVA research tells us that relatively few active managers can outperform passive managers over any given period, either short-term or long-term. But the accurate measure of successful active management is whether a manager or strategy can deliver above-average returns consistently over multiple periods. Demonstrating the ability to outperform repeatedly is the only proven way to differentiate a manager’s skill from luck.

How to start investing?

You can get started pretty quickly with index funds. But as with any investment, it’s still important to do your research before committing. So let’s walk through the steps to take when investing in index funds.

1. Set your goals

The way to make money in index funds is with patience and time. For example, according to Measure of a Plan, a personal finance website, while the S&P 500 has trended upwards over time, roughly 31% of the years in its history have delivered negative returns. On the other hand, there hasn’t been a single 20-year period in which it has lost money. 

31% of years have had negative returns. Source: Themeasureofaplan.com

Let’s examine the chart below: 

U.S. stock market annualized returns. Source: Themeasureofaplan.com

We see the market’s wild swings reduced if we start to consider time horizons that are longer than a single year. Looking at the 1-year view, we see lots of red, meaning there were plenty of years in which the market was down.

As we take a more extended period (from 5 to 20 years), the range of possibilities narrows, and the chance of losing money declines. Once we zoom it out to look at 20-year periods, you won’t see any more flashes of red. 

To sum up, it seems that with index funds, you will eventually make money no matter what, and the longer you have/, the earlier you start, the beefier your returns. 

2. Pick an index

When researching an index, it’s essential to consider several different factors:

  • Company size and capitalization: index funds can track small, medium, or large companies (cap indexes);
  • Geography: some funds focus on stocks that trade on foreign exchanges or a combination of international exchanges;
  • Industry: you can find funds that focus on specific sectors, such as consumer goods, technology, and healthcare, or funds that combine the best performers from a variety of sectors;
  • Security type: some funds track domestic and foreign bonds, commodities, and cash;
  • Market opportunities: funds that examine emerging markets or other fast-growing sectors for investment.

You may need to invest in only one despite the array of choices since one fund will already combine a variety of companies. However, you can easily customize your allocation if you want additional exposure to specific markets in your portfolio.

Index examples

Index mutual funds can track various indexes. Here are some options:

  • The Standard & Poor’s 500: one of the best-known indexes and widely considered the primary benchmark for U.S. equities, with various mutual funds and ETFs tracking it. It features 500 leading U.S. publicly traded companies representing multiple industries, with a primary emphasis on market capitalization. As a result, S&P 500 index is the most highly regarded as a barometer of the overall stock market’s performance and an indicator of how large corporations are performing;
  • Nasdaq Composite: follows more than 3,000 equities listed on the Nasdaq stock exchange and is largely tech-focused;
  • Wilshire 5000: includes all publicly traded companies with headquarters in the United States, often dubbed the “total stock market index;”
  • Dow Jones Industrial Average: measures 30 blue-chip companies in the U.S. and covers all industries except for transportation and utilities.

3. Pick a fund

After choosing the index you’re interested in, there are usually a few options for funds that mirror that index. Typically, different funds that track the same index will have similar performance histories, so often, this choice boils down to cost. 

Low costs are one of the most powerful selling points of index funds. Operating costs are cheap because they’re automated to follow the shifts in value in an index. However, even though a team of analysts does not actively manage them, they carry administrative costs. Of course, these fees are then subtracted from each fund stockholder’s returns as a percentage of their combined acquisition. 

Finally, two funds may have the same investment goal yet have considerably different management costs. Those fractions of a percentage point may seem insignificant at first. Still, your long-term investment returns can take a substantial hit from the smallest fee inflation—generally, the bigger the fund, the lower the fees.

3 Index fund examples

Let’s briefly examine three major funds that track the S&P 500 and compare their expense ratios as well as how their performance measures up against the index they follow. 

  1. Vanguard S&P 500 ETF (VOO)

The Vanguard S&P 500 tracks the S&P 500 index, and it’s one of the biggest funds on the market, with hundreds of billions in the fund. It began trading in 2010 and is sponsored by Vanguard, one of the powerhouses of the fund industry. 

The expense ratio is 0.03 %, meaning $10,000 invested would cost $3 annually.

  1. iShares Core S&P 500 ETF (IVV)

Another long-time player that has followed the S&P 500 since its inception in 2000 is the iShares Core S&P 500 ETF. It is one of the biggest ETFs and is backed by one of the heavyweights in the industry, BlackRock. 

The expense ratio is 0.03 %, meaning every $10,000 invested would cost $3 annually.

  1. SPDR S&P 500 ETF Trust (SPY)

You can think of the SPDR S&P 500 ETF as the grandfather of ETFs, having been founded back in 1993. It, too, tracks the S&P 500 and is sponsored by State Street Global Advisors. It helped launch ETF investing that has become so widespread today, and with hundreds of billions in the fund, it’s among the most popular ETFs. 
The expense ratio is 0.0945 %, meaning every $10,000 invested would cost $9.45 annually.

Index funds compared to the S&P 500 index they track. Source: Fool.com

As we can see, there are only meager differences between the S&P 500 index and the three funds that track it. But, as expected, the S&P 500 outperformed each fund slightly when accounting for each fund’s expense ratio.

Nonetheless, with any one of these three funds, you can anticipate your investment to return virtually identical performance to the S&P 500. 

4. Decide how much you want to invest

While it may feel meaningless to start investing if you don’t have much capital, it can still be incredibly worthwhile. Remember, few, if any, start investing with a large sum of money. For most, growing your wealth happens over the years and is a gradual and consistent process.  


Recommended read: 17 Common Investing Mistakes to Avoid


By starting slowly, even with a meager sum of money, you can begin to establish the habit of investing regularly, hopefully leading to a sizeable nest egg in the future.

The beginning of the investing journey is often the most challenging, as growth will initially seem limited. However, today’s tools, like digital investment advisors and online broker apps, make it easier to get rolling. 


Recommended read: 6 Basic Rules of Investing


And by getting started today, you’ll have time by your side. Extending the time your money sits in the market allows for compound interest to take over, which is when your interest and gains stack on top of one another. So you’ll want to add money regularly to the account and aim to hold it there for at least three to five years to allow the market enough time to rise and recover from any significant downturns.

For example, imagine investing $100 a month for 30 years, your total contributions adding up to $36,000. The average yearly return of the S&P 500 over the last 30 years is 10.7%, but even at a conservative return of 8%, after 30 years of monthly $100 payments, you would have over $146,000, which means your money would have quadrupled in value.

Essentially, the more money and time you have in the market, the more likely you are to grow your investments.

Automate your investments 

Once you have decided how much you can and are willing to invest each month, it’s vital to budget a certain amount of money that s taken out of your checking account on a regular schedule and automatically deposited into your choice of investments – a practice called dollar-cost averaging. Choosing this option is crucial because it takes the leg work away from needing to invest each month.

Additionally, studies show that humans are built for present bias, the theory in which the farther away in the future something is, the less important we think it is. In short, it’s much easier to spend now rather than save for later. Therefore, automating transfers from your checking account or paycheck into an investment account will help ensure you don’t waste the cash you intended to invest. 

So, by automating your investments, you will be passively growing your holdings and moving closer to reaching your financial objectives. Moreover, you may also want to consider investing on autopilot, i.e., a robo-advisor like Wealthsimple

Robo-advisors gather information from you on your financial situation and investing goals in suggesting investments that fit your requirements and risk tolerance. Then, they will build you a portfolio based on your answers by utilizing automated algorithms and advanced software with minimal effort from your end. In addition, it will help rebalance your investments over time based on your goals and changes in the market. 

5. Purchase the index fund

To invest in an index fund, you need to buy shares of that fund. You can invest in index funds through a taxable brokerage account or tax-advantaged retirement accounts, like your 401(k) or traditional or Roth IRA. These accounts allow you to buy ETFs or mutual funds, including stocks and bonds, if you decide to do so.

If you don’t have an account, you’ll need to open one, which you can do through an online broker such as Interactive Brokers, Robinhood, Charles Schwab, or Fidelity in a relatively straightforward process of 15 minutes or less. Pick one that matches the kind of investments you’re planning to make. Remember that the best brokers offer thousands of ETFs and mutual funds without a trading fee. 

Note: Some, but not all, brokerage accounts require a minimum investment to get started. 

Pros & Cons of index investing 

Index funds are popular with investors for several reasons. Most importantly, they allow for high portfolio diversification. Thus, managing risk and offsetting potential losses. However, low risk, as always, can result in a reduction in profits as you also won’t get exposure to the potentially astronomical returns resulting from picking a single epic winner. 

Benefits

  • High diversification: these funds allow you to hold a stake in hundreds or thousands of companies at once;
  • Low-risk: diversification cuts back on risk. The poor performance of one company won’t be as damaging when you own so many;
  • Low fees: index funds tend to have lower costs (expense ratios) than actively managed funds. The fund’s operating costs are reduced since there’s no need for portfolio managers or stock analysts or to pay commissions that arise from constant trading;
  • Stable performance:  index funds have consistently beaten other types of funds in terms of total return. For instance, index funds that track the S&P 500 have historically delivered an average 10 percent annual return over long periods;
  • Easy to acquire: buying into an index fund gives you access to an investment portfolio of a vast basket of securities. The time and expertise to build and maintain a similar portfolio yourself would likely be unthinkable;
  • Transparency: many index funds simply keep what’s in the index, so you can always see the fund’s holdings, letting you better judge an index fund’s risk based on those holdings;
  • Lower taxation: by trading in and out of securities less frequently than actively managed funds, index funds generate less taxable income that will be passed along to their shareholders.

Drawbacks

  • Lack of flexibility: index funds aren’t likely to deliver a return higher than the benchmark. While the investor is guaranteed the index’s return when the market rallies, so too the index’s loss when the market plunges;
  • Average annual returns: index funds may provide a high degree of diversification, which also means they deliver only average yearly returns. Index funds can dilute the possibility of considerable gains as they are driven by the combined results of a massive basket of assets;
  • Unlikely significant short-term gains: as passive investing vehicles, there’s little scope for capturing major short-term gains with index funds;
  • Tracking error: this is the variation between an index fund’s return and the performance of its parent index, mirrored by the costs to run a portfolio. Always go for the one with a slighter tracking error when you’re comparing index funds that track the same index;
  • Management differences: index funds are not always objective as they’re created by companies that decide an index’s composition. In addition, the decision-making process isn’t always appropriately regulated nor transparent and can be influenced by overall management tactics. Moreover, sometimes the index funds and the parent index have the same managers, which can create a conflict; 
  • Vulnerable to market swings and crashes: Many index funds are formed on a market capitalization basis, meaning the top holdings have inflated weight on overall market movements. For example, it would substantially affect the entire index if heavyweights such as Amazon.com Inc. (AMZN) and Meta Platforms Inc. (FB) experienced a weak quarter.

In conclusion 

For novice and long-term investors alike, buying an S&P 500 index fund offers a way to own a broad collection of equities at low cost while still enjoying the benefits of diversification and lower risk. Moreover, it’s relatively simple to find a low-cost fund and set up a brokerage account, even if you only had a basic introduction to them.

However, while index funds have consistently outperformed actively managed funds and can be excellent investments, they’re not all equal, so it’s crucial always to do your research to find one to suit your goals and budget.

FAQs about index investing

What is an index fund?

An index fund is a mutual fund or exchange-traded fund (ETF) whose portfolio mirrors the performance and composition of a financial market index, like the S&P 500. They seek to match the risk and return of the market based on the approach that the market will outperform any single investment in the long term.

How to invest in index funds?

To invest directly in index funds, you need a brokerage or retirement account. Then, once you have determined how to invest, you can place a buy order for an ETF or mutual fund that tracks your chosen target index.

How much money is needed to start investing?

Some funds allow you to start investing with as little as ten dollars. Some funds, however, require a minimum to get started. For example, Vanguard’s 500 Index Fund (VFIAX) requires a $3,000 minimum investment to open an account. As with all investments, remember not to invest more than you can afford to lose, especially if you don’t have emergency savings. 

How many index funds should I invest in?

The number of index funds you own should depend on how diversified those indexes are. If you invest in highly diversified funds, you may only need one to two. On the other hand, if you invest in targeted funds that track specific industries, you may want to own many funds to build a broad, diversified portfolio. 

Do index funds have fees?

Because index funds are passively managed, their fees are generally lower than actively managed funds. For example, many index funds offer costs of less than 0.20%, whereas active funds often charge more than 1.00%.

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Diana Paluteder
Author

Diana is an economics enthusiast with a passion for politics and investing. Having previously worked as a financial translator, she provides in-depth articles and guides on the world of finance and commerce.

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