What Are Index Funds — and How Should They Fit Into My Portfolio?

We delve into the pros and cons, the cost, and if an index fund is right for you.

Once upon a time, investors bought and sold stocks in individual companies, trying to beat the market’s average return. Then, in the early twentieth century, the mutual fund — a single fund that held positions in multiple securities (usually stocks)— was born. The market evolved again when, in 1976, the first index fund became available.

An index fund is a kind of mutual fund that is designed to match the performance of an index, such as the S&P 500. Rather than making active stock picks, these funds are “passive.” In other words, instead of a portfolio manager trying to select the most attractive stocks for a fund, index funds are run by an algorithm with virtually no human input. So, when a new company gets added to the S&P 500, an index fund designed to match it would automatically add that company, too. Over time, investors in an index fund should enjoy a similar performance compared to that of the index itself.

“An index fund allows an investor to diversify among many different investments efficiently and generally at a low cost,” says Leslie Thompson, CFA, CPA, managing principal at Spectrum Management Group.

Index Funds vs. Other Investments

Purchasing individual stocks “can be fun and rewarding,” Thompson says. But it also takes a significant chunk of time, and transaction costs can add up significantly. In addition, investors must pay taxes on every sale. These issues often make the simplicity of an index fund a better option for most people, Thompson says.

While all mutual funds represent a combination of different stocks, most are actively managed, meaning they employ stock pickers to regularly make trades in an attempt to beat the market.

That can be good for investors—if the stock pickers do a good job—but that scenario may also come with additional fees. Some mutual funds charge investors transaction fees, as well as a management fee to pay the stock pickers.

In contrast, because most index funds are passive, managed by algorithms rather than people, they tend to cost less. This can especially be important for funds invested in a 401(k) plan, which already charge an overall management fee.

For most lower- or middle-class investors, especially beginners, index funds may be the best way to invest successfully.

 

Potential Disadvantages

“Although there is a good place for index funds within an investor’s portfolio, there are separate advantages to holding individual company stocks,” adds JJ Kinahan, chief market strategist at TD Ameritrade.

While index funds can allow investors to track the market without spending a lot of time on researching and picking stocks, such funds aren’t perfect. “Like any pooled investment vehicle, you have no choice in the investment of the underlying securities,” Thompson says. “If you want to avoid a certain sector or want to have more or less concentration in a particular holding, an index fund may not be a good fit.”

Diversification is a benefit to index funds, but it can be overdone. If you own several different index funds, you may end up owning holdings in the same companies over and over again. So if you’re investing in the most basic index funds, you probably don’t need several different ones in your portfolio.

In addition, index funds have become very popular during the past few years during this long-lasting bull market. But what will happen to these funds when the market turns? “Many have not tested index funds in bear market conditions,” Kinahan warns.

 

Final Thoughts

If you want to try investing in an index fund, there are many to choose from. The most common funds mirror the S&P 500, but there are also “more obscure index funds such as those that track proprietary indexes, such as the NASDAQ OMX Global Water Index,” Thompson notes.

While the more obscure indexes may be interesting, they are often less transparent and possibly less liquid, which means it’s harder to know what they own and could be harder to sell them should you want to get out.

“The lack of transparency and lack of liquidity can increase the expense associated with the fund,” Thompson says. “Similar to a mutual fund, you should read the prospectus to understand the index that the fund tracks and how it is developed and maintained. You should also review how many assets are invested in the fund.”

New index funds regularly come to market, but there are also funds that close because of lack of interest, Thompson adds.

If you’re ready to try index funds, the amount you should invest in the fund depends on your own preferences. If you know you’ll never actively manage your own investments, and prefer not to hire a professional to do it, you may want to put a significant chunk of your holdings into such funds. Consider starting with one or two index funds that track the most common indices, such as the S&P 500.

At the end of the day, there is one overarching theme to keep in mind, Kinahan notes. “[I]nvestors should always understand what they’re investing in, be aware of the funds they’re holding, and understand the risk of their investments.”

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