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What is an Index Fund?

| MoneyRates.com Senior Financial Analyst, CFA
min read

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If you've spent any time looking into investments, you've probably run across the term "index funds." But just what is an index fund and how does it work?

Low-cost index funds can be the most efficient way to get broad representation in a variety of financial markets.

However, while low cost is a key advantage of index investing, it is not the only thing to consider. Tracking error and liquidity are two other important factors to evaluate when choosing an index fund.

Index investing starts with a choice of which markets you want to participate in. That's the most important investment decision you will make as an investor in index funds.

Once you've made that decision, you'll need to determine which funds best meet that investment objective. This article covers what you need to know to make that decision, including:

  • What index funds are
  • How index funds work
  • Advantages and limitations of index investing
  • How to invest in index funds

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What is an Index Fund?

To understand index funds, it helps to start with the concept of a market index.

Market indexes are things like the Dow Jones Industrial Average or the S&P 500. These aim to measure the performance of an investment market by compiling the changes in value of a representative sample of stocks in that market.

The Dow Jones Industrial Average and the S&P 500 measure the performance of large, U.S. stocks. There are also stock indexes based on smaller stocks, foreign stocks and individual industry sectors.

Besides stocks, there are market indexes designed to measure the performance of bonds, real estate and other asset classes.

Index funds are designed to mimic the performance of market indexes. They typically do this by constructing an investment portfolio that replicates the make-up of a particular index as closely as possible.

By imitating these indexes rather than picking individual investments on their merits, index funds are not intended to beat the market. They are designed simply to give you full participation in a particular market.

How Do Index Funds Work?

Since index funds are based around mimicking a particular index, the nature of that index goes a long way toward determining how an investment in that fund will do.

Below are some of the key characteristics of an investment index.

Investment type

Indexing can give you broad participation in an investment market, but there are several types of markets from which to choose.

You need to decide what type of investment you want and then choose an index fund geared around that type of investment.

For example, there are different market indexes for U.S. and international funds, and for government and corporate bonds. The performance of these indexes will differ according to the types of investments they include, so you need to choose a fund based around an index that matches the type of investment you want to make.

Composition

What an index is made up of determines how it reflects the performance of a certain type of market.

For example, suppose you want to invest in U.S. stocks. There are multiple indexes based on U.S. stocks, and each captures the market in a different way.

The Dow Jones Industrial Average may be the best-known U.S. stock index. Its composition is also the narrowest of the major U.S. stock indexes, as it includes just 30 stocks. These are very large, well-established companies.

As its name suggests, the S&P 500 has a broader composition of 500 stocks. This captures a wider slice of the U.S. stock market.

The NASDAQ Composite Index is even broader in composition than the S&P 500 and includes a heavier weighting of smaller and technology companies.

As you can see, each index represents a different window on the U.S. stock market. The nature of the investment you make in an index fund will depend on the composition of the index that fund is designed to replicate.

Weighting

How stocks are weighted in an index may seem like a technicality, but it has a big impact on the performance of that index. Here are three ways to weigh stocks in an index:

  1. Price-weighting

    The Dow Jones Industrial Average is price-weighted. This means the higher the price of a stock, the bigger a portion of the index it will represent.

    So, a stock selling for $60 per share will have twice as much impact on the performance of the index as one selling for $30. That may sound like it makes sense, but may not actually be representative of the size of the two companies. The $30 company may actually be bigger than the $60 company if it has more than twice as many shares outstanding.

  2. Capitalization weighting

    An alternative method of weighting is capitalization weighting. "Capitalization" refers to the total size of the company. So with this form of weighting, the bigger the company, the greater the impact it will have on the index's performance.

    The S&P 500 is a capitalization-weighted index, as are most indexes.

  3. Equal weighting

    Another method is equal weighting. This simply means that if you have 100 stocks in an index, each will represent 1% of that index.

    Equal weighting allows smaller companies to have more impact on an index's performance. This can help an index better reflect the success of smaller, more dynamic companies but it can also increase the risk of the index.

Pros and Cons of Index Investing

Index investing is often called passive investing because it simply accepts the performance of a particular market rather than trying to make active decisions in an attempt to do better than that market.

Passively managed funds have some advantages and limitations:

A solution to FOMO

The problem with making active decisions is that those decisions can be wrong. Bad investment decisions can result in missing out on the performance of the market.

An indexed approach is designed to make sure you don't miss out. It can help you capture the performance of your chosen market, for better or worse.

Lower fees

Passively replicating an index is a simpler job than trying to make active decisions to try to beat the index. As a result, index funds typically have much lower fees than actively managed mutual funds.

Lower taxes - at times

Index funds are sometimes touted for their tax advantages. This can be true, but only under certain circumstances.

The idea is that, since they are passively managed, sales of stocks within an index fund are less frequent. This means fewer realized gains throughout the year.

Over time, though, gains in stock prices within the funds will be fully taxable at some point.

Also, if when there is a high volume of redemptions (that is, people selling their shares of the fund) as a proportion of the size of the fund, it will trigger a high volume of sales of securities within the fund. That can result in a larger tax liability for the remaining shareholders of the fund.

In any case, both active and passive investors typically have a tax liability for dividends or interest paid on securities in the fund throughout the course of the year.

Asset allocation

One shortcoming of indexing is that passive investing leaves the most important investment decision up to the investor rather than to the professionals running the fund.

You have the responsibility for choosing which index you want to participate in, and this has the biggest impact on how your investments do. However, you can get the advice of professional advisors or use a robo-advisor to guide your asset allocation decisions.

Passive acceptance of market conditions

Another limitation of index investing is that it means passively accepting current market conditions.

This is fine when markets are doing well, but markets also go through extended periods of low returns and/or high risk. A passively manged approach makes no attempt to account for poor market conditions.

What Are the Best Index Funds to Invest In?

When choosing the best index funds to invest in, the one with the highest returns in the past is not necessarily the best choice.

Index investing is intended to ensure full participation in a particular market. This means the best index funds are those whose composition most accurately reflects that market.

You can also measure how well a fund's performance has matched the performance of the index it is designed to follow. The difference between the performance of an index fund and that of its designated index is known as tracking error.

One thing that consistently helps keep tracking error down is low cost. So, cost is a big factor in determining the best index funds to invest in.

How to Buy Stock Index Funds

To help you pick the right stock or other type of index fund, here is a review of some of the main concepts discussed in this article. These are all things you should look at when buying an index fund.

Investment mandate

Choosing the right index fund starts with deciding which type of market index you want to invest in. This can be based on your outlook for a particular type of index or on picking an index that fits in well with other investments you are making.

Expense ratio

This includes the management fee and any other expenses charged to the fund. The lower the expense ratio, the better your chances of keeping up with the index you're trying to follow.

Tracking error

Compare the historical performance of the fund with the index it is supposed to track. Your goal shouldn't be to pick the one with the highest return but the one whose performance most closely follows that of the index.

Size

The top index funds by size manage hundreds of billions of dollars. This can create efficiencies of scale which drive costs down.

Ultimately, though, you should check the expense ratio to see if size really translates to low cost. In some cases, size can be a problem as explained below.

Liquidity

For indexes like the S&P 500 which represent huge, heavily traded markets, liquidity should not be a problem. However, for more thinly traded markets, being part of a big fund can be a drawback.

If a fund has large inflows or outflows of investor money relative to the size of the index it is trying to track, it can have trouble buying or selling the necessary amount of stock to keep in step with the index. This type of liquidity problem can increase tracking error.

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Pursuing Your Financial Strategy

Index funds are widely available through online brokers, and also are commonly used as part of a broader asset-allocation strategy by robo-advisors.

Explore ways to step into the market with a personal financial advisor or online investing platform. Select a financial goal below to see a curated list of investment options and a select group of specialists ready to help you get started.

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