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What Are Index Funds? Definition & FAQs

Written by JD Esajian

The concept of investing is simple, but the act of actually doing so is a bit more nuanced. If for nothing else, there are countless ways to invest capital and build wealth. Today’s greatest investors, for that matter, will diversify their portfolios amongst many different holdings. From equities and commodities to real estate and cryptocurrencies, all sound investments may contribute to a proper wealth-building strategy. It is worth noting, however, that Warren Buffet, perhaps the greatest investor ever, suggests index funds are the most ideal option for both veteran and green investors.

Index funds have become synonymous with today’s most diversified investment strategies and prolonged capital growth, which begs the question: What is an index fund?. Outside of serving as a low-cost, low-maintenance, and superbly diversified investment vehicle, index funds are a great place to start investing. By tracking the major market indices, index funds tend to offer stable growth over long periods of time and award patient investors.

What Is An Index Fund?

In order to understand what an index fund is, it may be a good idea to familiarize yourself with mutual funds. A mutual fund is a pool of money that’s collected from several (or many) different investors. Professional financial managers handle the money and allocate it to a variety of different investments to try and generate profits. Investors don’t directly own any of the stock that the mutual fund purchases. Instead, each investor gets an equal share of the fund’s profits relative to their initial contributions (likewise, each investor would take an equal loss in the event share prices dropped).

An index fund, on the other hand, is a mutual fund that invests in stocks that track the major market indices. More specifically, index funds build portfolios with the goal of mimicking the performance of a specific index. A market index tracks the performance of many different stocks in a specific industry or economy. Here are some of the main indexes in the United States that are tracked by a respective index fund:

  • S&P 500 Index Fund: Tracks the performance of about 500 of the largest publicly-traded companies in the U.S.

  • Dow Jones Industrial Average Index Fund: Tracks the performance of the 30 largest U.S. companies

  • Bloomberg Barclays U.S. Aggregate Bond Index Fund: Tracks the performance of the U.S. bond market

  • Nasdaq Composite Index Fund: Tracks the performance of about 3,000 tech companies

  • Russell 2000 Index Fund: Tracks the performance of 2,000 smaller companies

The manager of a standard mutual fund will cherry-pick stocks from a variety of indexes. The success of the mutual fund depends on the collective success of the chosen stocks. But when you invest in an index fund, your profits will match the overall performance of the entire index in which you invested. Let’s say, for example, you invested in an index fund that holds stocks in the S&P 500. When the S&P 500 rises in value, index fund profits will rise proportionally. Profits and losses will match those of the entire sector.


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Index funds for beginners

How Index Funds Work

As their names suggest, index funds strive to replicate the performance of a specific market index. In doing so, index fund managers take up a passive investment strategy dictated by the stocks that make up the respective index itself. Instead of picking any equity they feel like, index fund managers must build a portfolio based on the individual market cap weightings of the stocks that make up the index they want to replicate. By building a portfolio that mimics a particular index, index funds allow investors to invest in an entire index without buying each stock individually.

The Pros Of Index Funds

To break it down, the common benefits of index funds for beginners include:

  • Low-cost

  • Less risk

  • Simple

Arguably the most beneficial aspect of index funds is that they’re low-cost. Index funds almost always outperform standard mutual funds over a long period, mostly because financial managers do not handle index funds. That means there are no costly maintenance fees that detract from your profits.

Learning how to invest in index funds can also lead to substantial tax benefits. With an index fund, less buying and selling is going on than if you were buying individual stocks. You’ll have far less capital gains tax to pay.

Index funds are also less risky than mutual funds and individual stocks. The main goal of a standard mutual fund is to “beat” the market—that is, to invest in stocks that perform better than their benchmark indices. However, this is very difficult to do and it often fails. It’s much safer to bet on the performance of an entire sector. Timothy Woods, owner, director, and editor of Carnivore Style says that “the most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing the likelihood of losing some or all your money”. He goes on to say “it carries low risk and steady growth and also asks for low fees”.

Index stocks tend to rise over time, so there’s a better likelihood that you’ll see good returns on your investment than if you invested in high-risk, high-reward stocks.

Furthermore, index stocks are highly diversified, which means they include dozens or even hundreds of different stocks. Your profits are unlikely to be damaged much if one or two companies suffer major losses. And the wide number of available stocks will enable you to invest in both stocks and bonds, which is the main diversification goal for many investors.

Last, but certainly not least, index funds are very easy to invest in. That’s especially important if you’re a new or part-time investor.

When you invest in an index fund, you won’t have to spend any time researching individual stocks and gauging which stocks might make the best investment. Short-term losses won’t hinder you, and you’ll also have the option to reinvest your earnings month after month automatically.

Because index funds are most cost-effective and profitable over a long period, it’s a great investment option for those seeking to develop a strong retirement fund.

The Cons Of Index Funds

Now that we have covered how they can benefit you, here the drawbacks of index funds for beginners to take note of:

  • Can’t beat the market

  • No loss protection

  • Fewer stock options

Unfortunately, because index funds are designed to match the market, you’ll never be able to earn more than the market. Every investor dreams of buying stocks at a company that’s going to explode in growth and profitability—the next Google or Amazon.

You won’t be doing that kind of investing with an index fund. Your profits will match the profits of the market, with no exception. There’s no doubt that a mutual fund that’s personally managed by a financial professional has the potential to yield the most lucrative returns.

There’s no loss protection with index funds, so if the market takes a nosedive, there’s nothing you can do to avoid taking a proportional loss. When you invest in individual stocks, you might have the option of ordering a stop-loss—your broker will automatically sell your stocks if they fall to a certain price. You don’t have that option with an index fund.

Lastly, you don’t get to choose which stocks are included in the index fund. There may be stocks that you don’t want, or it may exclude stocks that you do want.

It should be noted that all of these drawbacks could be countered by diversification. If you were to mix index funds with other types of investments, then you can minimize your losses and also invest in stocks that you’re willing to take a risk on. An index fund is just one tool in your investment toolbox.

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How To Invest In Index Funds In 4 Steps

Let’s explain how to buy index funds, step by step. It’s a fairly easy process—you just have to know what you’re looking for. Here are the 4 steps to investing in index funds beginners can follow:

  1. Decide Where to Buy

  2. Select an Index

  3. Consider Investment Minimum and Costs

  4. Buy Index Fund Shares

1. Decide Where To Buy

First, you need to decide where you want to buy your index fund. You can buy directly from a mutual fund company or a brokerage. Later on, we’ll suggest a few good places to look. Here are some of the things you should consider when choosing a provider:

  • Selection: Every provider will offer a different variety of funds. The larger mutual fund companies often sell their index funds plus their competitors’ index funds. However, a broker might offer funds that have a greater variety of included stocks. Shop around and find the provider that has what you’re looking for.

  • Ease of Use: If you’re only looking to buy index funds, you might be better off purchasing from a mutual fund company. But if you’re looking to invest in both index funds and other types of securities—like stocks and bonds—you might prefer using a broker. A broker can handle all different types of investments for you, and there will be less paperwork come tax season.

  • Trading Costs: Some providers waive transaction fees, but others don’t. Mutual fund companies tend to charge a commission that’s about $20 or more. Consider your budget and the overall profitability of the index fund.

2. Select An Index

Decide which index you’d like to invest in. It should be noted that the S&P 500 is a popular index for index funds because it tracks a very wide range of large companies, and in a variety of industries. But there are plenty of other indexes to choose from that might better suit your investment goals. You can choose an index based on several different factors:

  • Company size and capitalization: An index may track small, medium, or large companies.

  • Foreign: An index might track stocks that trade on foreign or international exchanges.

  • Sector or industry: Some indexes track companies that are in a specific industry (for example, technology or health)

  • Asset type: Some indexes track stocks, while others track bonds, commodities, or cash

  • Growing markets: Some indexes track markets that are emerging or growing rapidly, which might make for good investment opportunities

How do you know which index you prefer? Learn as much as you can about the different indexes and pay attention to what’s going on in the trading world.

3. Consider Investment Minimum and Costs

As mentioned earlier, index funds are desirable because they’re low-cost. But that doesn’t mean that all index funds cost the same. Some have higher administrative fees than others.

Here are some of the costs you should consider:

  • Investment minimum: Index funds require you to invest a minimum amount of dollars. Sometimes the investment minimum can be thousands of dollars or more. Once you’ve made the investment minimum, you can continue to invest in smaller increments.

  • Account minimum: If you’re purchasing a mutual fund from a broker, know that your broker may require you to have a minimum amount of money in your brokerage account.

  • Expense ratio: This is one of the main index fund costs. It’s the percentage that you pay from your overall investment that goes toward administrative fees. The average annual expense ratio is 0.09% for stock index funds and 0.07% for bond index funds.

  • Capital gains: You’ll have to pay capital gains tax on index fund profits unless you hold the index fund in a 401(k) or IRA (for those of you purchasing from a broker). Typically you’ll have to pay 0.3% on returns.

4. Buy Index Fund Shares

Prior to investing in an index fund, investors will need to know which type of account they want to open. Consequently, investors have several options at their disposal: standard brokerage accounts, retirement accounts, investment accounts for kids, and others are just a few of the options. Investors need to know which type of account they want to hold the index fund in before they buy shares. Each account has its own pros and cons, so be sure to pick the account that meets your specific needs. With the proper account open, all that’s left to do is purchase shares of the index fund.

Other Considerations

Index funds are relatively easy to understand, but they still require maintenance. Monitor the performance of your investments over time and pay attention to benchmarks over time. You want to make sure you aren’t losing more money in fees than you’re making, and that the index fund is performing according to the underlying index. It can take a little getting used to, but over time you will know what to watch for as you keep your portfolio in check.

As you review the various ins and outs of index funds, you may find yourself leaning towards alternatives. Some investors prefer a more active role in their portfolios. If you want to explore trading, try investigating stocks. Investors looking for a lower-cost alternative to both options may find exchange-traded funds (ETFs) to be a better fit. Overall, there are numerous considerations to make when building your portfolio with index funds.

Is Now A Good Time To Invest In Index Funds?

To be perfectly clear, there isn’t a perfect time to invest in index funds. Despite what anyone tells you, it is practically impossible to time the market. Even at a time when it feels like stocks can’t go down anymore, it’s entirely possible for the rug to be pulled out from underneath all of Wall Street. If the last few years have taught us anything, it’s that the market is impossible to predict without an inherent degree of error. In just two year’s time, for example, the stock market experienced its largest single day decline in the wake of the pandemic, only to be followed by more than a year of record growth.

Today, the stock market is still dealing with the ramifications of the actions that were taken to combat COVID-19. Years of government stimuli have resulted in the fastest rate of inflation we have seen in about four decades. As a result, the Federal Reserve has had to increase interest rates to combat inflation, all with a looming recession on the horizon. To make matters more unpredictable, there are growing geopolitical tensions, a weakening Euro, and global supply chain issues. All things considered, nobody knows what will happen in the near term.

That said, there’s one thing that’s more important than timing the market: time in the market. The longer someone stays in the market, the greater their chances are of realizing a positive return. In the entire history of the stock market, stocks tend to go down faster than they go up, but they almost always go up longer than they go down. With that in mind, now is a great time to invest in index funds for investors with long-term investment horizons. Now that valuations have come in a lot, long-term investors may view today as a buying opportunity (as long as they can handle some short-term volatility).

Invest in index funds

The 5 Best Index Funds For Beginners In 2022

What are the best index funds for new investors? It’s difficult to compile a “best of” list because every investor has a different budget, risk tolerance, and investment goals.

If you’re new to investing, however, you might consider opening an account at a brokerage firm that sells index funds. A brokerage firm is a good investment hub, and it may also offer certain invaluable benefits, like investment advice—which can help you pick an index fund. If you decide to further your investment career, you’ll appreciate the convenience of managing all your investments in one place.

If, on the other hand, you are more inclined to pick your own index funds, here’s a good list to choose from:

  1. Vanguard 500 Index Fund Admiral Shares (VFIAX)

  2. Schwab S&P 500 Index Fund (SWPPX)

  3. Fidelity 500 Index Fund (FXAIX)

  4. Fidelity Zero Large Cap Index (FNILX)

  5. T. Rowe Price Equity Index 500 Fund (PREIX)

Vanguard 500 Index Fund Admiral Shares

One of the best index funds to invest in today is the Vanguard 500 Index Fund Admiral Shares. Trading under the ticker symbol VFIAX, the Vanguard 500 Index Fund Admiral Shares seeks to track the performance of the Standard & Poor‘s 500 Index that measures the investment return of large-capitalization stocks. In doing so, this fund’s top holdings include:

  • Apple Inc

  • Microsoft Corp

  • Amazon.com Inc

  • Alphabet Inc Class A

  • Tesla Inc

  • Alphabet Inc Class C

  • Berkshire Hathaway Inc Class B

  • Johnson & Johnson

  • UnitedHealth Group Inc

  • NVIDIA Corp

Year to date, the Vanguard 500 Index Fund Admiral Shares is down about 19.98%, right in line with the S&P 500. However, the market appears closer to a bottom than ever before, which means now may be a great time to invest in a fund that tracks 500 of the largest U.S. companies.

Schwab S&P 500 Index Fund

Those interested in low-cost index funds should take a look at the Schwab S&P 500 Index Fund. As its name suggests, the Schwab S&P 500 Index Fund attempts to mimic the returns (or losses) of the S&P 500 index. At least 80% of the fund’s $59 billion in assets is reserved for the stocks that make up the index it tracks. This particular fund gives the same weight to its investments as the index itself. The funds top holdings include:

  • Apple Inc

  • Microsoft Corp

  • Amazon.com Inc

  • Alphabet Inc Class A

  • Tesla Inc

  • Alphabet Inc Class C

  • Berkshire Hathaway Inc Class B

  • Johnson & Johnson

  • UnitedHealth Group Inc

  • NVIDIA Corp

Year to date, the Schwab S&P 500 Index Fund is down about 19.96%, right in line with the S&P 500. Not unlike the previous fund, the Schwab S&P 500 Index Fund is getting closer to a bottom. That’s not to say the bottom is in yet, but rather that now would be a good time to dollar-cost average.

Fidelity 500 Index Fund

With a management fee of 0.02%, the Fidelity 500 Index Fund is among today’s best low-cost index funds. Like those listed above, the Fidelity 500 Index Fund tracks 500 of the biggest companies on Wall Street. As a result, this fund is a bland of both growth and value stocks with an average risk profile. The funds top holdings include:

  • Apple Inc

  • Microsoft Corp

  • Amazon.com Inc

  • Alphabet Inc Class A

  • Tesla Inc

  • Alphabet Inc Class C

  • Berkshire Hathaway Inc Class B

  • Johnson & Johnson

  • UnitedHealth Group Inc

  • NVIDIA Corp

Year to date, the Fidelity 500 Index Fund is down about 19.97%, right in line with the S&P 500. Much like the S&P 500, the Fidelity 500 Index Fund has done nothing but drop this year. While there may still be room to the downside, today’s valuations are more attractive than they were at the beginning of the year.

Fidelity Zero Large Cap Index

Another low-cost index fund, the Fidelity Zero Large Cap Index has no management fee or expense ratio. In return for investing in the Fidelity Zero Large Cap Index, investors will gain access to about $5 billion in total assets, about 80% of which is invested in large capitalization companies on the Fidelity U.S. Large Cap Index. As a result, the fund’s assets are reserved for large, growth companies and seeks to provide an above-average return. The funds top holdings include:

  • Apple Inc

  • Microsoft Corp

  • Amazon.com Inc

  • Alphabet Inc Class A

  • Tesla Inc

  • Alphabet Inc Class C

  • Berkshire Hathaway Inc Class B

  • Johnson & Johnson

  • UnitedHealth Group Inc

  • NVIDIA Corp

On the year, the Fidelity Zero Large Cap Index has remained in line with the S&P 500. As a result, long-term investors may view today as a great time to invest in one of the best index funds that has no fees.

T. Rowe Price Equity Index 500 Fund

Another one of the best index funds to invest in is the T. Rowe Price Equity Index 500 Fund. Similar to the other funds that made the list, the fund seeks to track the performance of the S&P 500. By focusing on a blend of large growth and value companies, the T. Rowe Price Equity Index 500 Fund offers investors the ability to invest in quality at a time when perhaps nothing is more important. The funds top holdings include:

  • Apple Inc

  • Microsoft Corp

  • Amazon.com Inc

  • Alphabet Inc Class A

  • Tesla Inc

  • Alphabet Inc Class C

  • Berkshire Hathaway Inc Class B

  • Johnson & Johnson

  • UnitedHealth Group Inc

  • NVIDIA Corp

Down about 20.04% on the year, T. Rowe Price Equity Index 500 Fund has kept pace with its respective index. As a result, it would be hard to argue that this fund isn’t one of the best index funds to start a position in today.

Alternatives to Index Funds

If you decide that index funds aren’t right for you, you still have plenty of other investment options to choose from. One option is stocks. These are shares of individual companies that you can own. You could also opt for Exchange Traded Funds (ETFs) and mutual funds, which are both different types of collections of stocks that can be actively or passively managed. To learn more about fixed-income ETFs, be sure to read our guide on getting started.

Summary

Index funds are a type of mutual fund whose profits match the gains and losses of an entire sector. Knowing how to buy index funds is beneficial because they’re low-cost, less risky, and simple to purchase and manage. However, they’re not optimal for the high-risk investor because they’ll never earn more than the market. An index fund might be a good investment for you if you’re looking for a stable long-term investment that’ll provide solid returns. It’s a terrific investment option for retirement planning.


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