An index fund is a kind of mutual fund that mirrors a financial market index, like the S&P 500. So an S&P 500 index fund would invest in companies included in the S&P 500 index, and the fund’s performance would keep pace with the index.
Index funds have a reputation for being a simple, inexpensive way to invest in the stock market. While all that’s true, does that mean they’re the best choice for your retirement account? Let’s break down index funds so you can decide whether or not they have a place in your investment plan.
What Is an Index Fund?
As we explained above, an index fund is a type of mutual fund designed to mirror the makeup and performance of the stock market or a particular area of the stock market.
A mutual fund lets investors pool their money together to invest in something. So in the case of an index fund, your money is used to invest in stocks, bonds or other types of investments that are included in a particular index.
Index funds are a pretty simple form of investing, and many of the prepackaged fund options you see in employer-sponsored 401(k) plans are index funds. You can also invest in index funds in an individual retirement account (IRA).
How Do Index Funds Work?
In order to understand how an index fund works, it’s important to understand what an index is.
When it comes to the stock market, an index is basically a measuring stick. Indexes help investors measure the performance of the stock market.
There are hundreds of different indexes out there to measure many of the different sectors of the stock market. The S&P 500 index, for example, is the one most experts use as a benchmark for the overall U.S. stock market.
Standard & Poor (S&P) is a ratings agency that identifies the top 500 largest companies on the New York Stock Exchange to include in its index. In a very real way, they use it to measure the overall performance of the stock market.
Like we said earlier, the investments inside an index fund depend on the index the fund is based on. So that S&P 500 index fund we talked about, for example, is made up of stocks from the companies found inside the S&P 500. And its goal is to track with the performance of that index. So, if you invested in an S&P 500 index fund, you own 500 stocks in a single fund with returns that are almost identical to the gains (or losses) of the S&P 500 itself.
This is what makes index funds a passive or indirect form of investing. Instead of being run by a fund manager looking for investments that will beat the market, an index fund is more than happy to settle for “average,” by copying the performance of the index they’re based on. No better and no worse.
What Are the Advantages of Index Funds?
If there’s one thing we tell everyone who’s getting started with investing, it’s this: Never invest in something you don’t understand. You need to have a good grasp of your investing options before deciding to invest your hard-earned money into anything. And that means weighing the pros and cons of all your options—including index funds.
Here are some of the pros of having index funds in your investment portfolio.
Index funds are diversified.
Like we mentioned earlier, index funds are a type of mutual fund. And like other mutual funds, index funds invest in stocks from hundreds of different companies. That gives you a nice layer of diversification to help smooth out the ups and downs of the stock market and increase your potential for long-term returns. Sweet!
Index funds have lower expense ratios.
Because index funds just copy the index they’re named after, there’s not as much for a fund manager to oversee. That’s why it’s called “passive” management. Because of that, index funds usually have lower fees and expense ratios.
Index funds are predictable.
With an index fund, you know you’ll get returns that are more or less the same as the stock market. And just like the stock market, there are going to be ups and downs—but long term, the value of your index fund will grow along with the index.
What Are the Disadvantages of Index Funds?
Index funds might be less risky than single stocks, bonds or even some other mutual funds, but there are a few things you should keep in mind before adding index funds to your investment mix.
Index funds won’t beat the market.
Index funds will give you an average rate of return based on stock market conditions, which is great for growing your savings for a down payment or buying your first rental property. We’re talking about more predictability and a lot less risk than some of your other options for growing long-term (five or more years) savings.
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But when it comes to your main retirement savings, index funds aren’t your best option. You want those investments to beat the market, not just match it. So we recommend going with actively managed mutual funds for your main retirement nest egg and leaving the index funds for your smaller financial goals.
Index funds are not very flexible.
The company an index fund invests in isn’t up for debate. It only changes if the index it’s based on changes. So, the holdings inside your S&P 500 index fund, for example, will only change if the S&P 500 drops some companies for others in its index.
Some index funds have higher maintenance fees.
You’ll hear a lot about lower expense ratios from index fund crusaders. But hold up! While it’s true that many index funds have lower expense ratios than actively managed mutual funds, they’ll charge a hefty maintenance fee—sometimes listed as a 12b-1 fee—to make up for it. And those can really hurt your returns in the long run. Be on the lookout for those!
What Are Some Different Types of Index Funds?
From bonds to foreign stocks and everything in between, there are hundreds of indexes out there used to track the performance of almost every sector of the financial market you can think of. And if there’s an index for it, you can almost bet your bottom dollar there’s an index fund for it.
We’ve already talked about the S&P 500 index fund, which is probably the most famous example of an index fund out there. But that’s just the tip of the iceberg. Here are some other common index funds you’ll find, and you’ll notice that each one has its own unique flavor:
- Russell 2000 Index Fund: This fund is made up of stocks that are in the Russell 2000 index, which focuses on smaller companies.
- Wilshire 5000 Total Market Index Fund: Made up of almost 3,500 stocks, the Wilshire 5000 is the largest U.S. stocks index, and it measures the performance of America’s publicly traded companies.
- MSCI EAFE Index Fund: Whoa, that’s almost half the alphabet right there! All you need to know is this index fund mirrors the performance of the international stock market, with foreign stocks from Europe, Australasia and the Far East (that’s what “EAFE” stands for) included in the mix.
- Barclays Capital U.S. Aggregate Bond Index Fund: This index fund is very different from the others in this list because it follows the performance of the U.S. bond market. So the fund invests in bonds instead of stocks. Bonds are basically loans where the government, cities or businesses borrow money from investors and agree to pay them back, with interest. With bonds, you are the lender and the government, city or business is the borrower.
- Nasdaq Composite Index Fund: This fund has stocks from around 3,000 companies listed on the Nasdaq exchange, which is often used to measure the performance of the technology sector.
- Dow Jones Industrial Average (DJIA) Index Fund: The Dow Jones is the oldest stock market index in the U.S., made up of stocks from 30 large companies from all kinds of different industries. This index fund includes stocks from companies that are included in the Dow Jones index.
Remember, with an index fund, don’t expect to get returns that are better or worse than the index the fund is mirroring. Basically, the market’s returns are your returns.
Should Index Funds Be Part of Your Investment Strategy?
If you’re looking for a safe place to park your savings for five or 10 years, it’s hard to beat an index fund. They’re designed to mirror the market, so they’re relatively low-risk and predictable.
Index funds will give you an average rate of return based on stock market conditions, but like with all investing, the longer you keep your money in an index fund, the more likely you are to see growth. That makes them a great option for growing your savings for a down payment or buying your first rental property.
But when it comes to your main retirement savings, choose mutual funds that have track records of beating the market, not matching it like an index fund. After you’ve paid off all your consumer debt and have an emergency fund in place, invest 15% of your gross income in good growth stock mutual funds in tax-advantaged accounts like your 401(k) at work or a Roth IRA. Look for funds that have a long track record of strong returns that beat stock market indexes like the S&P 500.
Your retirement investments should be divided evenly between four types of mutual funds:
- Growth and Income: These are the most predictable funds in terms of their market performance.
- Growth: These are fairly stable funds in growing companies. Risk and reward are moderate.
- Aggressive Growth: These are the wild-child funds. You’re never sure what they’re going to do, which makes them high-risk, high-return funds.
- International: These are funds from companies around the world and outside your home country.
That way, your retirement investments will be well-diversified—which means you’re not keeping your entire nest egg in one basket. But you’re still going after funds that historically beat the market and help you build a nice, big nest egg for retirement over time.
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Now look, some mutual funds underperform the stock market—and you want to stay far away from those—but there are many mutual funds out there that outperform the market. Picking the right funds is a game-changer when it comes to investing!
It’s always a good idea to sit down with a pro who can help you set goals for your financial future and help you understand all your options, from index funds to growth stock mutual funds.
Our SmartVestor program connects you with investment professionals in your area. Each one has been vetted by our team here at Ramsey Solutions, and they will patiently walk you through the investing process.
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Frequently Asked Questions
What is the difference between index funds and mutual funds?
Mutual funds are investments that allow investors to pool their money together to invest in stocks or bonds, for example. Most mutual funds are actively managed, meaning they have a team of professionals working behind the scenes picking and choosing those stocks, bonds or other investment options to include inside the fund. The goal is to put together a collection of stocks that outperform the average stock market index.
An index fund, as we discussed above, is a type of mutual fund designed to match the performance of the stock market or a particular area of the stock market. Unlike mutual funds, index funds are passively managed. The fund simply buys shares of stocks that are included on the index it’s based on instead of relying on a team of experts to pick the stocks.
How much do index funds cost?
Because index funds aren’t actively managed, they often have fewer fees and lower expense ratios. You’re not paying the behind-the-scenes team of professionals to choose which stocks or bonds to include in your index fund like you would for a mutual fund. But it’s not all sunshine and roses and no fees—here are some of the costs you can still expect for index funds:
- Investment minimum: Just like mutual funds, index funds have a minimum amount to get started investing. It can be anywhere from nothing to a few thousand dollars, but once you’ve hit that minimum requirement, most funds will let you add money in smaller contributions.
- Account minimum: This number is completely different from your investment minimum. Your brokerage may have an account minimum of $0 or $1,000, but it doesn’t affect or take the place of your index fund’s investment minimum.
- Expense ratio: A fund’s expense ratio includes all of its operating expenses, including transaction fees, taxes and accounting fees. It’s one of the main costs of an index fund. But because index funds are passively managed, your expense ratio will be lower than it would be with a mutual fund.
- Maintenance fees: Also known as 12b-1 fees, maintenance fees can get downright ugly when it comes to index funds. They can end up making an index fund more expensive than commission-based funds, so keep an eye on them.
- Capital gains taxes: Investing in index funds or mutual funds outside of tax-advantaged accounts like 401(k)s or IRAs can have huge tax implications, like triggering capital gains taxes. That’s one reason why it’s so important to talk with your tax and investing professionals before you invest.
What is the difference between index funds and actively managed funds?
Mutual funds are one example of actively managed funds, which simply means they have a group of investing experts actively working to find the right stocks to include in their fund.
Index funds, as we’ve discussed above, have passive management. They just copy whatever index the fund is supposed to mirror, which means your index fund goes up when the market is up and down when the market goes down. Not too complicated, but not as good for your retirement savings as actively managed funds like good growth stock mutual funds, either!
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.