What is an Index Fund?

An index fund acts like a mime...

It tries its very best to replicate the makeup of stock indexes, such as the S&P 500, and seeks to move just like the stock market index does.

An index fund is built by a portfolio manager. Their job is to construct a portfolio of stocks that tracks a stock index as perfectly as possible. If the fund manager has done a good job, then in theory, the share price of the fund should move exactly in sync with the stock market index it’s trying to match (this is not always the case).

Let’s say an index fund is trying to track the S&P 500. The fund manager would buy stocks in a proportion that’s equivalent to the 500 stocks in the S&P 500. That way, each share of the fund is like a mini S&P 500 stock. An index fund aims to do no better, and no worse, than the stock market index it’s tracking.

• If the S&P 500 rises 1%, the fund should rise by about the same.
• If the S&P 500 is flat, shares of the fund should be just about flat, too.
• If the S&P 500 falls 1%, shares of the fund should move about the same amount.

Keep in mind that an index fund may not perfectly track its index. For example, an index fund may only invest in a sampling of the securities in the market index and, as a result, may over or underperform its index. Also, transaction costs could prevent an index fund from matching the performance of its index.

There’s a stock index that’s calculated to track the movement of lots of different stock segments. There are stock indexes for entire countries, for entire sectors, and combinations of the two. There are even indexes for bonds. And for each popular market index, there’s likely a mutual fund or ETF that’s been built to track it. Here are some of the most watched stock market indexes, which have index funds available for investors to buy and sell:

• S&P 500: The 500 largest American public companies
• Russell 2000: 2000 small and mid-cap US companies
• Dow Jones Industrial Average: 30 blue chip US stocks
• FTSE 100: 100 of the largest companies based in the United Kingdom
• Shanghai Composite Index: An index of all the stocks on the Shanghai Stock Exchange
• DAX: 30 of the top large-cap stocks in Germany
• … the list goes on and on. If there’s a certain country or a certain sector you’re interested in, there may be an index fund that tracks a stock market index for it.

Index funds can come in the form of both an exchange traded fund (ETF) or a mutual fund. For example, there are both mutual funds and ETFs that aim to mimic the S&P 500 index.

There are two schools of thought on Wall Street. One believes there are opportunities to “beat the market.” Another believes it’s futile to try to beat the market. To beat the market, an investor must generate returns on their portfolio that are better than the stock market in general (as measured by a given index or benchmark).

Passive investing: This school of thought believes it’s not worth it to try to “beat the market.” They believe stock prices are generally “correct” based on the information available to investors. So why would you spend mental energy trying to pick stocks? If every stock is correctly priced, then it’s a waste to try to beat the market. In fact, you’ll probably lose — your returns will be worse than the market — if you try to pick stocks.

• Investors who believe in passive investing prefer index funds because they’re designed to simply match the market.
• Many mutual funds and ETFs are passively managed. That means that the fund manager just tries to track or match a stock market index or some other market benchmark, instead of using their own discretion to choose the best stocks for the fund. Since the decisions of a fund manager are relatively simple, the fees the manager can charge are relatively low.
• Index funds are passively managed.

Active investing: This school of thought believes that certain humans are better than the market. They know that certain stocks are mispriced, meaning they should be worth more or less than they are now. Active managers believe they’re smart enough to perform enough research to help them pick what they believe are the winners whose prices are going to rise and avoid the losers, whose prices are going to fall.

• Investors who believe in active investing prefer to pick their own stocks, instead of just investing in an index fund.
• Many mutual funds and ETFs are actively managed. That means the fund manager uses their expertise and information to decide what individual stocks are, in their opinion, best, then they fill their portfolio with those investments. Since the manager is using their “special sauce” in an attempt to pick winners and avoid losers, they charge a higher management fee.
• Active managers focus on stock picking and timing of their buys and sells in an attempt to “beat the market.”
• Index funds are not actively managed.

To sum it up, passive investors tend to prefer index funds. Active investors think they can do better than index funds, so they’re more likely to pick stocks themselves or purchase actively managed mutual funds.

Costs are key for index funds — especially the fact that they tend to be lower than other types of funds since they typically require less management than a more actively handled fund. Although there isn’t necessarily a huge team of researchers and analysts running the show behind an index fund, there are still some administrative, trading, and other costs taken out of the investors’ returns.

Here are a couple key costs to keep in mind when it comes to index funds:

• Account and investment minimums: Some index funds have a minimum amount required in order to invest (for example, $2,000). These minimums may also have thresholds that you cross, letting you invest more by adding smaller increments.
• Expense ratios: This is the core cost, which is taken out of your returns from the fund as a percentage of your overall investment. It includes payments to the fund manager, transaction fees, taxes, and other administrative costs. The more actively managed a fund, the higher the expense ratio is likely to be, since the fund manager is investing in more research and analysis and wants to be compensated for that. For an index fund, the expense ratio is likely lower. It’s important to understand the expense ratio before making the investment because they can erodes a fund’s underlying returns.

Index funds can exist as both ETFs and as mutual funds. The key difference between the two tends to be the cost — Mutual funds tend to have higher expense ratios than ETFs.

Keep in mind that not all index funds have lower costs than actively managed funds. Always be sure you understand the actual cost of any fund before investing.

If you want to invest in stocks, but don’t know what stocks to invest in, an index fund could be an investment you may want to consider.

Strengths

• Low cost: Funds offer investors the opportunity to invest in tens, hundreds, or thousands of stocks with one single purchase. For that privilege, fund managers charge fees to investors. A closely watched measure of fees is an Expense Ratio — an expense ratio of 1% means that the fund will take 1% of your investment as its own fee. Index funds have some of the lowest fees of all investment funds available.
• Diversification: Don’t put all your eggs in one basket. The same advice generally goes for investing. Studies have also shown that a stock portfolio that includes stocks that don’t move closely in sync with each other is likely to perform better overall than a stock portfolio full of similar stocks. Index funds can offer good diversification if the underlying index that they track is diverse as well. Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.

Weaknesses

• Lack of Flexibility: An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
• Tracking Error: An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index.
• Underperformance: An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

John Bogle, founder of Vanguard, is known for reminding investors: “Don't look for the needle in the haystack. Just buy the haystack!” What he means is that stock picking is hard (finding a needle in a haystack), but you’re guaranteed to pick the best stocks if you buy the entire stock market.

Bogle was a huge proponent of low-cost mutual funds and passive investing. He built one of the first index funds for individual investors in 1976. Famed investor Warren Buffett also believes that average investors should buy an S&P 500 index fund instead of picking individual stocks because the fees are low and it offers good diversification.

It’s important to know how much an index fund charges in fees when deciding whether or not to invest. Keep in mind, managers typically charge a fee even if the index fund loses money. More information about an index fund’s fees and expenses can be found in a legal document called a “prospectus.” The prospectus also provides detailed information on the index fund’s investment objective, principal investment strategies, risks and historical performance (if any). You can get a fund’s prospectus by contacting the mutual fund or the financial professional selling the fund. Read the prospectus carefully before investing — it’s packed with critical info in what you’re about to put your money into.

Robinhood Financial LLC does not offer mutual funds. For more information about index funds, see the SEC’s Investor Bulletin. For more information about mutual funds and ETFs, see the SEC’s Guide for Investors, the FINRA's investor resource on mutual funds, and FINRA's investor resource on exchange traded funds.

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