An index fund is a specific type of mutual fund or exchange-traded fund (ETF) and a great way to diversify one’s investment portfolio. An index fund’s purpose is to track the movements of a market index, which serves as a benchmark for how tradable assets like individual stocks, bonds, and commodities are doing. They’re a relatively stable entity.
Read on to learn more about what an index fund is, how it works, the benefits of investing in one, and how an index fund compares to an actively managed fund.
What is an index fund?
A financial index fund is a type of investment fund that mimics a specific index, or hypothetical collection of stocks, associated with a particular segment of the market. The act of “mimicking” is so that the index can match market trends and remain relevant.
Investing in indices has become more popular over the last few years. This type of investment is called a passive investment strategy, which maximizes profit by minimizing trading activity.
The S&P 500 index is the most popular index and the most commonly tracked index in the United States. The Dow Jones Industrial Average (DJIA), Wilshire 5000 Total Market Index, Russell 2000, Nasdaq, and Bloomberg Barclay US Aggregate Bond Index are a few other major stock indexes.
How index funds work
Index investment funds essentially invest in the same entities that the market indices invest in, like the DJIA. This causes diversification within investor portfolios and allows such parties to access more of the market.
Indices let investors buy entities in a significant number of sectors including technology, energy, and agriculture. They can also work with both small and large businesses.
Index funds benefits
The perks of investing in an index fund include:
One: They’re low risk. Index funds don’t try to “outsmart” the market. Instead, they operate based on the notion that the market always wins over the individual when generating returns. Copying the market’s actions establishes a relatively low threshold risk for investors. The value and the returns earned by indices usually increase over time.
Two: They come with low costs. Individuals who invest in index funds don’t frequently participate in trading, so investors don’t need to pay transaction or commission fees. And, they don’t require as much, if any, oversight, so you don’t need to pay a market research analyst for their services.
After you buy into an index stock, you’re responsible for paying an expense ratio, which balances a fund’s operating expenses against its value. The most affordable index stocks have a less than 1 percent expense ratio to cover the administrative costs of an external party operating and managing the fund, making them quite affordable.
Three: They’re less complex. The market can seem like a scary, complicated thing, but with index funds, you’re only monitoring the progress of the benchmark indexes they mirror and nothing else.
Index funds versus actively managed funds
There are two primary types of investment management strategies one can adopt: passive and active. Index funds fall under the former category.
Actively managed funds mean that a third party, also referred to as a fund portfolio manager, chooses which stock indexes to invest in and devises a plan regarding how and when these indices should be bought or sold.
The following are the two biggest differences between index (or passive) funds and actively managed funds.
You could face a variety of fees if you choose to work with a portfolio fund manager. These costs can include advisory fees, transaction fees, accounting fees, and general taxes.
Since index funds just copy what a benchmark index does, they don’t require supervision or a stock market strategy. Compared to the low index fund costs, firms that deal with actively managed funds often charge a one to two and a half percent fee for their expertise.
Overall, passively managed funds tend to yield higher returns than active ones over an extended period. Actively managed funds rely more on the human element, which can increase fallibility. The S&P 500, for example, boasts approximately 10 percent average annual return for investors.
Index funds are better regarding long-term success, while active funds are better for achieving short term investment goals.
What are Index ETFs?
Index funds can also come in the form of an ETF. ETFs are portfolios of stocks managed by financial fund companies. For example, if a certain stock comprises 5 percent of an index, then the index ETF portfolio will contain 5 percent of that stock.
Should you invest in index funds?
If you’re considering investing, here are some characteristics of index funds to help you decide. Index funds are best:
One: For those who have a low-to-medium risk appetite when it comes to their personal investment objectives.
Two: For those who want to invest in the stock market passively and, by extension, experience less stress about being a part of the stock market.
Three: For those who prefer lower fees.
Four: For those who want to invest less time in investing.
Ultimately, investing in indices is an intelligent, safe way to reduce financial risk and grow your wealth. But investing isn’t the only way to do that. If you equip yourself with the right tools and use them daily, you’ll earn additional money over time while gaining confidence navigating the market.
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