Index Funds: What They Are and How They Work

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When you start investing in the stock market for the first time, the thought of having to choose your own investments can be enough to discourage anyone from getting started. But what if you could invest in the entire stock market?

That’s where index funds come in.

Index funds are a type of investment vehicle that have become increasingly popular in recent years. In fact, the Wall Street Journal went so far as to declare index funds the new “Kings of Wall Street” in one 2019 headline. Investors love index funds since as a cost-efficient way to build wealth with a proven track record over the years.

So what exactly are index funds and how can you get started investing for retirement? Keep reading to learn what they are, how they work, and why you may want them in your portfolio.

What Is An Index?

Before we get into how to start investing in index funds, it helps to understand an index. In the financial world, an index is a measurement of the performance of a group of underlying securities. An index typically tracks a particular sample of the market. 

You may have heard of the S&P 500 and the Dow Jones Industrial Average, (DJIA) as those are two of the most popular indexes. The S&P 500 is a market index made up of 500 of the largest companies in the stock market. The Dow Jones Industrial Average is an index that tracks 30 of the largest and most-traded blue-chip companies in the market.

What Is An Index Fund?

Index funds give you broad exposure to large segments of the entire stock market with a single fund. They tend to be low-cost and help you diversify your investment across multiple assets within your portfolio. That means your money isn’t tied to one single stock, which helps protect you from any downturn in the market. 

Index funds track a specific index, and there are many different types of index funds. Depending on the index fund, your investments can be automatically organized across different types of stocks, bonds, or other asset classes.

How Do Index Funds Work and How To Get Started

The goal of an index fund is to match the market, not beat it. In the case of an S&P 500 index fund, the goal is to achieve returns identical to that of the S&P 500. When an individual invests in an index fund, they essentially invest in every security that makes up the underlying index.

Pro Tip

Investing in index funds rather than individual stocks allows you to diversify your portfolio and reduce your risk of loss if one company performs poorly. You can create a complete, well-diversified portfolio with just a few index funds.

You can get started investing in index funds pretty quickly. Keep in mind though that the name of this game is long-term, so it’s best if you get started early and plan to keep your investments for a long time.

First, pick an index. If you’re just starting out, a broad-based index fund (like the S&P 500 or a total market fund) is a good place to start. Look for index funds that have the lowest fees, also known as expense ratios. For example, Fidelity has a 500 index fund with a 0.02% expense ratio. Then you need to buy shares. 

You can invest in index funds through taxable brokerage accounts like Fidelity or Vanguard, or you can invest through your retirement accounts like a 401(k) or a traditional or Roth IRA. Once you buy shares, be sure to continue to invest every month. Even though index funds are great to set and forget, continuing to invest in them is key. Be sure to figure out your investment goal and continue to invest that much every month. A compound interest calculator can help you project earnings over time. You can use this calculator to figure out how much you need to deposit over a specific period of time to meet your goal. For example, if you deposited $10,000 into an investment account and that investment grew an average 7% for the year, you will have made $700. After 30 years and a 7% return, you will have made $76,000. Compound interest (and time) is the secret sauce in investing. 

Why Index Funds Make Sense

Experts love index funds and they have become increasingly popular over the past several decades, and for good reasons. Having diversification is key in a healthy portfolio and index funds provide that.

Diversification

Diversification is key in any portfolio. Index funds are great because it invests your money in hundreds — if not thousands — of securities in a single investment.

Investing in one single stock can be risky. “If you were invested in Apple, you open yourself up to how that company runs its business and whether it’s going to be profitable in the future,” said Michaela McDonald, a Certified Financial Planner for the financial services company Albert. “If you instead invest in an index fund that tracks that same sector, you shield yourself from that unsystematic market risk of a single company and can take part in how the industry is moving as a whole.”

Historical Performance

Index funds have been around for more than 45 years, and many of the indexes they track have been around far longer. As a result, there’s plenty of historical performance to look at to see how they perform. 

The stock market has an average annual return of about 10%. Similarly, the S&P 500 has had an average annual return of about 9.87% over the past 30 years. By investing in an S&P 500 or total stock market index fund, you’re able to replicate those returns.

Low Fees

Index funds often have lower fees, or expense ratios, than other funds on the market. These low fees allow investors to keep more of their earnings.

“It’s like going out to run a 5K,” said Landon Loveall, a Certified Financial Planner with KB Financial Advisors. “You don’t wear a backpack with weights in it when you run a 5K. That’s what fund expenses are like — they become a weight that holds your performance back. The lower those expenses, the better off you’ll be.”

While fees will vary from one index fund to the next, they’re often lower than 0.10%. Vanguard, a company that’s well-known for its index funds, charges expense ratios ranging from 0.04% to 0.07%. Charles Schwab charges as little as 0.02% for its S&P 500 index fund. “That’s like music to the ears of an index fund investor,” says Delyanne Barros, investing expert and founder of Slay the Stock Market investing course. Barros says she keeps 85% of her wealth in index funds. “We need to make sure we’re protecting our profits.”

Tax Efficiency

Index funds are tax efficient because there is less turnover ratio, that’s a number percentage calculated depending on how many companies are replaced in a fund. Funds with high turnover rates have higher taxes. Because index funds replicate a specific index, there isn’t much trading going on compared to other active funds. That’s not to say it doesn’t happen, but it doesn’t happen often. “There’s not a lot of swapping and trading going on because all it’s doing is mimicking the index,” says Barros. “But when Tesla was brought on to the S&P 500, funds had to be changed so it could include it but that doesn’t happen all the time.”

Index Funds vs. Actively Managed Funds

Index funds are passively managed, which means the fund manager isn’t actively buying and selling securities to try to outperform the market. Many mutual funds are actively managed.

“With an actively managed fund, the fund manager believes that their team can outperform the market and will actively trade to try to do that,” McDonald said. “With the index fund, you’re riding the market, and as it moves as it will, you’ll move with it.”

Unlike index funds, actively traded funds aren’t tied to the performance of a particular market index. Instead, the fund manager seeks out securities they think will have returns higher than the market as a whole.

The benefit of actively managed funds is that you have the potential to beat the overall market. The downside, however, is that it rarely happens. In fact, data suggests that more than 90% of fund managers underperform the market, meaning investors’ returns were lower than if they had simply invested in an S&P 500 index fund.

The fact is that no one can predict with complete accuracy what a single security or the overall stock market will do.

“It’s one thing to know which stock is going to outperform,” Loveall said. “Once that fund buys that stock, they’ve also got to be right on the timing because most stocks do not outperform forever. They’ve got to know not only what to buy, but when to buy them and when to sell them.”

Another difference between index funds and actively managed mutual funds is the cost. While index funds often have expense ratios below 0.10%, it’s not unusual for an actively managed fund to have an expense ratio greater than 1.0%.

FAQs

What is an index fund?

An index fund is a passively managed mutual fund that tracks the performance of a particular market index like the S&P 500 or the Dow Jones Industrial Average.

Are index funds a good investment?

Index funds can be a good investment because they provide a diversified portfolio and positive historical returns with low expense ratios and minimal taxes.

Can you lose money in an index fund?

Every type of investment, including index funds carries some level of risk. As a result, it’s possible to lose money. But index funds are a long-term investment strategy, and the market has historically trended upward. As a result, with a buy-and-hold strategy, you are unlikely to lose money.

What fees do index funds have?

Many index fees have expense ratios below 0.10%, and fees can go as low as 0.02% for popular S&P 500 index funds.