What is an Index Fund?
Stock market indices track the value of a large select number of stocks. You may have heard of the Dow Jones Industrial Average, Nasdaq and the Standard & Poor’s 500 (S&P 500). There are many indexes in the market that show the performance of the overall market and different sectors. The Dow Jones, measures the value of 30 stocks from reputable, profitable businesses, often referred to as blue chip stocks. The S&P 500 as its name suggests, follows stocks from 500 different large companies.
These indexes can work as a benchwork for the performance of a variety of investments. A lot of mutual funds and hedge funds compare their performance with the S&P 500 to see if they beat the yearly yield that this index provides. They also serve as an indicator to see how the market is doing. You’ll hear on the news, ‘the market surged 500 points,’ which is most likely referring to one of the previously mentioned indexes. For intraday trading, you can compare an individual stock to the S&P 500 or Dow Jones to see if it is following the current market sentiment.
There are thousands of indexes that track the movements of various sectors, markets, and investment strategies on a daily basis, and are used to determine that market’s stability and performance.
When an investor purchases a share of an index fund he or she is purchasing a share of a portfolio that contains the securities in an underlying index.
Index funds help to create a diverse portfolio without doing much work. Rather than balancing your asset allocations across the individual stocks you picked out, you can grab an index fund instead and own everything.
The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management.
Another benefit of index funds is that they allow investors to achieve their goals relative to benchmarks more consistently. For instance, consider an investor who wants to beat the market and is willing to take more risks to achieve that goal. Investing 90% in a low-cost S&P 500 ETF and 10% in a 2x S&P 500 leveraged ETF will often beat the market.
Since the assets behind index funds are frequently changing and there are not uniform reporting standards, it is far more difficult for an investor to determine exactly what they own than if they purchased a share of an individual corporations. This is particularly important for investors focused on corporate responsibility or impact investing.
As index funds follow the general direction of a market, it is susceptible to market crashes which would erase unrecognized gains. This type of investment also returns slow gains as it typically only moves up a couple of percentage points per day. Index funds lack flexibility as they are not managed by professionals, ultimately it lacks human element.
Index funds allow you to passively invest into a mirror of diversified assets. Unlike most funds, this particular investment does not require fees for professional management.
How they work
Index funds are a giant portfolio of different securities into one overall fund. These stocks collectively mirror the price and value of the index. For example, the S&P 500 is an index fund which consists of the performance of 500 different stocks. If the group of stocks in the S&P all go down, the index fund will mirror that and follow. If one particular stock has a bad day while the rest of the stocks in the index fund go up, you will typically not see a decline in the funds’ value, and if you do it will only be a fraction of a loss.
There is an index, and an index fund, for nearly every financial market in existence. In the U.S, the most popular index funds track the S&P 500. But several other indexes are widely used as well, including:
- Dow Jones Industrials Average (consisting of 30 large-cap stocks like Home Depot, Boeing, etc.)
- Russell 2000 (small cap stocks)
- Barclays Capital U.S. Aggregate Bond Index (bond market)
- Nasdaq Composite (aggregate of 3000 stocks listed on the Nasdaq exchange)
- Wilshire 5000 Total Market Index (largest U.S. equities index)
- U.S. Dollar Index (Ticker: DXY, follows the U.S. Dollar value)
The main difference between index funds and mutual funds is that the latter can be actively managed. Think of it like this. When you put your money in an index fund, you or your financial manager cannot remove specific equities from that specific index. You can’t remove Apple for the S&P 500, you are investing in the entire collection of securities.