Guide to understanding index funds
Guide to understanding index funds
Guide to understanding index funds
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When it comes to investing, many individuals aren’t comfortable picking and choosing individual stocks. That’s where investment options like index funds come in. These pooled investments allow individuals to gain exposure to many different assets at once.
Index funds have become increasingly common in the past couple of decades, especially as more investors are taking their portfolios into their own hands. There are thousands of index funds on the market, with different investment goals.
Are you considering investing in index funds but aren’t sure how to get started? Keep reading to learn more about what index funds are, how to invest in them, and whether they’re the right investment for you.
What are index funds?
An index fund is a type of investment vehicle that tracks the performance of an underlying market index or portion of the market. Some index funds track market indexes, such as the S&P 500 or the Russell 2000. Meanwhile, others track specific stock sectors, company sizes, etc.
An index fund is like a basket of securities, and when you invest in the fund, you’re investing in all of the assets within the basket. This allows investors to gain exposure to hundreds — or even thousands — of assets with a single investment.
Index funds can be either mutual funds or exchange-traded funds (ETFs). The two have many similar characteristics, but also a few important differences. Most notably, all mutual fund orders are placed at the end of the trading day. Meanwhile, ETFs can be traded throughout the day, just like stocks. Once they’re in your portfolio, they function very similarly. And though ETFs are generally more tax-efficient, that’s less relevant for an index fund where a fund manager isn’t regularly buying and selling assets.
Index funds can take several forms, including stock funds, bond funds, and mixed-asset funds. Stock and bond funds hold only one type of asset — either stocks or bonds. Mixed-asset funds, on the other hand, hold both stocks and bonds. The best type of index fund to invest in depends on your investment goals, risk tolerance, and time horizon.
Read more: Individual bonds vs. bond ETFs: Which is better?
Index funds vs. actively managed funds
Index funds are designed to track a particular underlying index or share of the market and their holdings don’t change often. For example, an S&P 500 index fund only changes when the makeup of the S&P 500 changes.
Contrast that with actively managed funds, which have a fund manager who frequently buys and sells assets with the aim of outperforming the fund’s chosen benchmark. While actively managed funds aim to outperform the market, index funds simply aim to match it.
Are index funds a good investment?
Index funds are among the most popular investments on the market, and for good reason. Some of their key benefits include diversification, lower costs, tax efficiency, and more. Let’s break down some of the most important benefits of index funds:
- Diversification: Index funds can provide diversification to your portfolio. Rather than investing in a single company, you can invest in hundreds or thousands of companies at once, helping to reduce your portfolio’s overall risk.
- Lower costs: Most investment funds have annual fees in the form of expense ratios. These fees account for the costs of running the fund. Because index funds don’t have fund managers who actively buy and sell assets regularly, they typically have lower fees.
- Tax efficiency: Index funds are generally more tax-efficient than their actively managed counterparts. Because the fund manager isn’t regularly buying and selling stocks, there are fewer taxable capital gains passed along to investors.
- Historical performance: Even though actively managed funds aim to outperform the benchmark index, index funds actually have a better track record.1
Of course, no single investment is best for every person and every situation. Index funds can be an excellent option for long-term investors who are saving for retirement or other future goals. To determine whether index funds are a good investment for you, you’ll first have to identify your investment goals.
Read more: Financial planning for your life
Are index funds suitable for beginners?
We’ve already discussed some of the key benefits of index funds. In addition to being a good overall investment, they may be particularly suitable for beginner investors.
One of the roadblocks that holds many people back from investing is the fear of choosing investments. Understandably, with thousands of publicly traded stocks on the market, it’s a daunting task to choose the right ones. That’s even more true when it comes to building a complete, well-diversified portfolio.
Index funds can take much of the guesswork out of portfolio creation for beginner investors. Rather than choosing many individual stocks and bonds, you can invest in just a few — in some cases, just one — index funds and have a fully diversified portfolio that you won’t need to tinker with.
Read more: Investment strategies: Guide for beginners
How to invest in index funds
Investing in index funds is a relatively simple process. And the good news is that once you get past the initial steps, it will be even easier to purchase more funds in the future. Here’s a step-by-step guide to start investing in index funds:
- Choose an investment platform: To invest in index funds, you’ll first need to have an investment account. There are many platforms to choose from. When comparing providers, be sure to consider the funds available, investment minimums, and fees.
- Open your investment account: Once you’ve chosen a platform, it’s time to open your account. It will take just a few minutes to do this, but you’ll need to provide some personal information, including proof of identification.
- Fund your account: You’ll have to connect your investment account to a funding account, usually a bank account. This is the account you’ll use to transfer money to your investment account to purchase investments.
- Choose an index fund: Once your investment account is open and funded, you can search from the wide variety of index funds available. The lineup of available funds will differ slightly depending on your investment platform.
- Place your buy order: After choosing an index fund, you can place your buy order. This process will be simple, but when and how your transaction is completed will depend on whether you purchase a mutual fund or ETF index fund.
- Automate your investments: If you want to invest in index funds on a regular basis, you can automate your investment purchases. For example, you could set up your account to purchase a certain dollar amount or number of shares of a particular index fund on the same day each month.
- Monitor your account: You’ll still want to keep tabs on what’s going on with your investments, so you should monitor your account regularly.
How to choose the right index fund
While investing in index funds is a relatively simple process, choosing the right funds is a bit more challenging. A quick search of index funds will provide hundreds of choices, so how do you know which is right for you?
Which index fund is best?
There’s not necessarily one index fund that’s best for everyone. Instead, the right index fund for you depends on your investment goals, risk tolerance, time horizon, and other factors.
There are many different approaches to index investing. Some investors choose to simplify the process as much as possible by choosing just one fund, such as a total market fund or a target-date fund. These funds will help give you a well-diversified portfolio.
Another option is to build your own multi-fund portfolio. For example, a popular approach is to build a three-fund portfolio with one domestic stock index fund, one international stock index fund, and one bond index fund.
Once you’ve identified the type of index fund you want to invest in, you’ll still find many options. For example, at the end of 2022, there were 77 S&P 500 index funds alone.2 All of these funds track the same market index, so the only real differences will lie in where you can buy them and the fees associated with them. There won’t be a notable difference in performance because they are tracking the same index.
What is the highest-paying index fund?
Strong index funds for you to consider are those that can provide proven long-term returns with lower fees. Remember, higher investment fees can reduce your overall return. Though the highest-paying index funds may differ over time based on the market cycle, there are plenty of options that have a proven track record.
Here are a few popular types of index funds that can help provide effective long-term returns:
- S&P 500 index fund
- Total stock market index fund
- Small-cap index fund
- Mid-cap index fund
- Large-cap index fund
- Russell 200 index fund
- Dividend index fund
- Growth index fund
- Total bond market index fund
Most index fund providers offer the types of funds listed above, meaning you can choose the investment platform and provider that you prefer based on its investment minimums, fees, customer service, and other features.
The bottom line
Index funds are among the most popular investments due to their diversification, low costs, tax efficiency, and other benefits. They’re an excellent option for beginners and experienced investors alike, especially those building a long-term portfolio to save for retirement and other future goals.
The first step to building an index fund portfolio is identifying your investment goals and risk tolerance so you can choose the right funds for your situation. While you can take this step yourself, you can also work with a financial advisor who can guide you along the way and help identify the best index funds and other investments for your goals.
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1 Financial Times, “Passive eclipses active in US fund market as assets swell to $13.3tn,” January 2024.
2 Statista, “Number of index mutual funds in the United States from 2000 to 2023, by index type,” April 2024.
Investing involves risk, including possible loss of principal.
Asset allocation, diversification, or rebalancing does not ensure a profit or protect against loss.
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