What is an Index Fund?
An index fund is an exchange-traded fund or mutual fund that replicates an investment in a basket of stocks or bonds found in an index.
The investments included in a stock index are selected based on a formula or common classification.
There are roughly 5,000 stock indices that divide the public market into classifications based on any number of factors. The most commonly cited index in the United States is the S&P 500, which tracks the performance of the 500 largest companies on the stock market.
Other popular indexes include the Dow Jones Industrial Average, the Nasdaq Composite, and the Russell 2000.
If you invest in an S&P 500 index fund, such as the SPDR S&P 500 ETF (NYSE: SPY), each share of the index fund represents an investment in all 500 companies that make up that index.
Because these funds simply track an index, there are no human managers making decisions about which individual stocks to buy or sell. For this reason, investing in an index fund is also referred to as passive investing.
Types of Index Funds
As long as an index is widely followed, there is probably a tradable index fund that corresponds to it. In many cases there are even more than one fund for the most popular indices.
Some common types of index funds:
- Funds tracking a broad swath of the stock or bond market (e.g., S&P 500)
- Funds tracking a specific country or region (e.g., a Brazil index)
- Funds tracking a specific industry or sector (e.g., a technology index)
- Funds tracking an investment theme (e.g., a robotics index)
Any classification criteria can be used to produce an index as long as it is transparent and investable. With institutional support, any index can be the basis of an index fund.
Index Funds: Pros and Cons
Index funds provide a powerful tool that has its place in an investor’s portfolio, but like anything else they have limitations.
The biggest pro of funds that track an index is that they are the easiest way to buy or sell a diversified basket of stocks or bonds. Each purchase of fund shares is, in effect, an investment with exposure to numerous underlying stocks.
For example, by buying the SPDR Dow Jones ETF (NYSE: DIA), an investor is immediately invested in the 30 stocks that comprise the Dow Jones Industrial Average.
This built-in diversity is a great way to smooth out returns. If a single company in the fund has a bad year it can have a real impact on investors. If one company out of the fifty or more in a fund has a bad year it has a much lower relative impact to returns.
The other major pro is that they are a lower-cost alternative to actively managed funds.
The typical passive fund that tracks and index costs 0.05% to 0.20% per year, compared to 1% to 2% (or more) per year for actively managed funds.
On the con side, index funds follow arbitrary rules for picking investments. This means that you cede a considerable amount of control over the specific holdings in the fund.
For example, the S&P 500 index simply takes the 500 largest public companies at any given time—and just because a company is large doesn’t mean it is an investment that aligns with your investing goals.
Finally, an index fund only follows the index it is designed to track. As an investor this limits your exposure to different strategies and it reduces your ability to react to negative market conditions.
If you pick a fund with a good active manager, that portfolio manager may be able to avoid some bad investments found in an index. This picking and choosing approach can potentially lead to better portfolio performance though it always comes with a higher cost.