What is an Index Fund?
An index fund lets you easily and at a low-cost invest in all the stocks that make up a stock index.
Deciding what stocks to invest in can be a challenge since there are many options out there. That’s one reason mutual funds and Exchange Traded Funds (aka ETFs) were created — they take a bunch of money from individual investors, put it in one big pot, and a fund manager uses the money to invest in different areas, strategies, or types. So a share of an investment fund is like a smoothie: A blend of different investments that an investor can easily buy. Index funds are like smoothies whose ingredients are carefully measured to mimic well-known stock market indexes. The result is a low-cost way to help make diversified investments. 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.
The S&P 500 is a large cap index that includes 500 leading U.S. companies and covers approximately 80% of available market capitalization (source: Standard and Poor’s). If you want to invest in these stocks, but don’t want to decide which ones, there are many index funds whose shares are built to closely track the movements of the S&P 500. That way, each share of the fund is like a mini S&P 500 stock.
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 exactly 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.
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 underperform its index. Also, transactions 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 reputable 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:
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.
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.
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:
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.
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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