Updated: May 30
Author: Gerda Laima Novada
Date of publication: 08/07/2022
Investing in index funds is one of the smartest investment moves you can make today. In fact, they are popular with investors because they promise ownership of a wide variety of stocks and bonds. Apart from this, they do so in low fees, and low risk since they're highly diversified. So, they tend to generate attractive returns over time. That's why many investors, especially beginners, find index funds to be better investments to individual stocks.
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF). It includes a portfolio constructed to track the performance of a specific market index. For example, the S&P 500 index defines 500 of the largest U.S. companies. Investing in an S&P 500 fund means your money is tied to the performance of a wide range of companies.
You can buy index funds through your brokerage account. Otherwise, you can do so directly from an index-fund provider, such as Vanguard. When you buy an index fund, you get a diversified selection of securities in one, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund. So that helps lower your overall risk through diversification.
A mutual fund is a type of financial vehicle made up of a pool of money. This money comes from many investors to invest in securities (stocks, bonds and other assets). Mutual funds are operated by professional managers. They allocate the fund's assets and produce capital gains or income for the fund's investors. The goal with mutual funds is to beat the market. However, the goal with index funds is simply to match the market’s performance.
Index funds may be structured as exchange-traded funds (ETFs). Financial firm manages portfolios of stocks, in which each share represents a small ownership stake in the entire portfolio.
ETFs will track a particular index, sector, commodity, or other asset. Unlike mutual funds, ETFs can be purchased and sold on a stock exchange the same way that a regular stock can.
How index funds work
“Indexing” is a form of passive fund management. Index fund manager builds a portfolio whose holdings mirror the securities of a particular index. Instead of a fund portfolio manager actively choosing securities to invest in.
When you put money in an index fund, it is then used to invest in all the companies that make up the particular index. That gives you a more diverse portfolio than if you were buying individual stocks. By imitating the profile of the index (whole stock market or part of it) the fund will match its performance as well.
Index fund manager builds a portfolio whose holdings mirror the securities of a particular index. Instead of a fund portfolio manager actively choosing securities to invest in.
Why index funds are so attractive to investors
Diversification- each index fund holds a selected collection of hundreds or thousands of stocks, bonds, or both. If a single stock in the collection is performing poorly, there's a high chance that another is performing well. That helps minimize your losses.
Time- minimize your time spent researching individual stocks. Instead of that, you can rely on the fund's portfolio manager. In this way you can invest in an index that includes stocks you want to invest in.
Lower fees- major reason is that they generally have much lower management fees. This comes in comparison with other funds because they are passively managed. Rather than having a manager actively trading, the index fund’s portfolio just duplicates that of it’s index.
Lower taxes- index funds don't change their stock or bond securities as frequently as actively managed funds. This results in less taxable capital gains distributions from the fund, which could reduce your tax bill.
Index funds offer investors of all skill levels a successful way to invest for the long term. They have several attractive pros, but also some cons to consider. For example, they will never beat the market. However, passively managed funds strategy instead seeks to match the overall risk and return of the market.
Warren Buffett is one of the most successful investors of all time. His investing style, based on discipline and patience, has consistently outperformed the market for decades. Investors can follow one of his recommendations: Low-cost index funds are the smartest investment most people can make.