Investments known as index funds are those that, by imitating the composition of benchmarks such as the S&P 500, replicate their performance. A growing number of investors are drawn to these passive investments, which were formerly thought of as an uninspired method of investing. However, they are causing a quiet revolution in the U.S. equities markets. The figures provide context: Just 21% of U.S. equity fund assets were passive index funds that tracked market benchmarks in 2012.1. Passive index funds accounted for about half of all U.S. fund assets by 2023.
There are numerous reasons for this, according to Autumn Knutson, founder and chief financial planner at Styled Wealth and a top-100 financial counselor on Investopedia. “Index funds are a low-cost way to track a specific group of investments, which can be more broadly diversified than individual stocks and simpler to buy than each of the individual holdings within the index,” she said. “They are very popular for people looking to invest in a group of investments in a simple and cost-effective way.”
Passive funds have seen a seismic change in popularity because they consistently beat their actively managed counterparts.32 About nine out of ten actively managed funds underperformed the S&P 500 benchmark in terms of returns during the last fifteen years, according to the widely used S&P Indices Versus Active (SPIVA) scorecards.
Because of this, detractors claim that managers of actively traded funds have taken more fees for themselves and given their investors less in return. We explain index funds and their operation below. We’ll also go over the advantages and disadvantages of using index funds to construct a portfolio.
Index funds: What Are They?
There are indexes and index funds for almost every segment of the financial industry. Index funds, which usually invest in stocks or bonds, use the same weights as the target index to purchase the same assets. If you’re interested in the stocks of an economic sector or the complete market, you may locate indexes that try to earn returns that closely resemble the benchmark index you wish to monitor. Index funds use a low-fee passive investment approach by trading as little as feasible.
To invest in wide indexes such as the S&P 500, it would be too costly or impossible to manually enter the appropriate amounts. Because they hold a representative sample of the securities, index funds do the job for you. The most well-known and established index funds in the US are S&P 500 index funds, which replicate the stock market movements of the S&P 500, which represents about 80% of all US equities by market capitalization.
Only when their benchmark indexes change do the portfolios of index funds undergo significant changes. The management of a fund that tracks a weighted index may adjust the weights, or the proportion based on market capitalization, and components of the fund’s holdings on a regular basis to maintain alignment with the benchmark index.
In addition to the S&P 500, these funds track other major indexes such as the Dow Jones Industrial Average, which consists of 30 large-cap stocks selected by the Wall Street Journal editors, the Nasdaq Composite Index, which consists of 3,000 stocks listed on the Nasdaq exchange, and the Bloomberg U.S. Aggregate Bond Index, which tracks the entire U.S. dollar-denominated bond market.
Depending on their underlying index, index funds provide wide market exposure and diversification throughout a range of industries and asset classes. Tracking errors—the discrepancy between the performance of the fund and the target index—are often quite well-minimized by the larger index funds.
Before making an investment, you should carefully consider the costs and performance of any fund. As of July 2024, Fidelity’s Nasdaq Composite Index Fund (FNCMX) has a 10-year average annual return of 16.37% compared to 16.34% for the Nasdaq composite, a 0.03% difference. This gives a sense of how closely the funds should match their goals.
Are Investing in Index Funds a Good Idea?
As Knutson pointed out, index funds are very well-liked by investors as they provide an easy, hassle-free approach to get exposure to a wide-ranging, diversified portfolio at a cheap cost. They often have low cost ratios since they are assets that are passively managed. These funds have the potential to provide all-encompassing returns during bull markets, as the market increases. There are drawbacks to them, however. One is the absence of downside protection; these funds may underperform the market as a whole during protracted downtrends.
Investors contemplating index funds have two primary avenues to pursue:
Self-directed research entails learning the fundamentals of index fund investing, keeping up with market developments and tax ramifications, and routinely assessing and modifying your portfolio.
Getting expert advice: Speaking with a financial adviser may help you choose a fund by providing you with a comprehensive overview of your portfolio and ensuring that your decision is in line with your overall financial objectives.
Despite the perception of index funds as a do-it-yourself investing option, Knutson said advisors can assist investors in creating a portfolio of multiple index funds that track different markets, such as a U.S. large-cap index fund, an international stock index fund, and possibly a U.S. and International Bond Index Fund.
This diversification technique may assist in distributing risk across various asset classes and markets. In order to make sure that no part of these assets becomes overweight or underweight, Knutson said, these portfolios should be “monitored for rebalancing.”
More complicated finances make it easier to see that you need expert help. According to Knutson, “if the account is taxable or if there are irregular contributions to an account, an advisor can be especially helpful.” “Otherwise, there could be tax efficiencies left on the table or the account could get more out of balance than preferred if there are no recurring contributions being put in to keep it rebalanced with each new contribution.”
Although index funds are a simple investment strategy for a lot of people, there are hundreds of options, so it’s not a one-size-fits-all method. Your objectives, risk tolerance, and financial status should all be taken into consideration when deciding whether to invest in index funds and how to manage them as a part of a larger portfolio. Making educated financial selections requires knowing the benefits and drawbacks of index fund investing, regardless of whether you decide to do it alone or seek expert advice.
Advantages of Index Funds
Lower costs are the main benefit that index funds provide over their actively managed counterparts. Consequently, more investors are questioning why they are paying fund managers so much more in fees annually if actively managed funds do not perform better than their passive counterparts. According to statistics last released in mid-2024, 79% of actively traded funds have underperformed the S&P 500 over the preceding five years when compared to a particular benchmark using SPIVA data as a proxy. That becomes 88% when you double that by 15 years.
The increasing acceptance of passive funds, which are essentially index funds, may be explained by a better public comprehension of this kind of information. With these funds, you are still required to pay an expense ratio, which is calculated as a proportion of the assets under management and is used to pay managers and advisers as well as for accounting, tax, and transaction fees.
Index fund managers don’t require research analysts or anybody else to choose stocks, time transactions, or do anything else since they are only copying the performance of a benchmark index. Also, they trade their assets less often, which results in lower commissions and transaction costs. In contrast, actively managed funds incur higher expenses due to their big staffs and more complex and volume of transactions.
Index funds may thus charge less than their counterparts that trade actively. In contrast to actively managed funds, which normally have fees of 0.44% and sometimes greater than 1.00%, depending on the assets, they often have lower costs, as low as 0.04%.
Let’s list the benefits in brief:
Reduced costs: Because index funds are passively managed, they usually have lower expense ratios.
Market representation: By providing a wide range of market exposure, index funds seek to replicate the performance of a certain index. For individuals seeking a diversified investment that follows broad market patterns, this is worth considering.
Transparency: The assets of an index fund are widely recognized and accessible on almost any investment platform since they mirror a market index.
Historical performance: Over the long run, several index funds have beaten actively managed funds, particularly after accounting for fees and expenditures.
Tax efficiency: Compared to actively managed funds, index funds with lower turnover rates often have less capital gains distributions, which makes them more tax-efficient.
These funds have numerous features that make them well-suited for typical long-term investors. Having said that, the optimal option for you—passive or active—depends on a number of factors, including your risk tolerance, investing environment, and financial objectives. Many have benefited from their comparable returns over the long run.
The Negatives of Index Funds
The intrinsic rigidity of index funds is one of their main criticisms. They can’t change course when the market moves, since they are made to reflect a certain market and lose value when it does.
They are also criticized for adding all equities in an index automatically. This implies that they could underweight assets that might provide higher returns in favor of investing in expensive or fundamentally poor enterprises. Naturally, this automated approach has consistently outperformed active management, maybe partially due to its tendency to cling onto assets that active fund managers have made mistakes in valuing.
Another drawback is the practice of “market-cap weighting,” which is used by many index funds. In these types of funds, the performance of the fund is more significantly influenced by companies with larger market capitalizations. Because of this concentration, you may become too dependent on the performance of a small number of very big corporations, increasing your risk if they perform poorly.
Are Stocks Better Than Index Funds?
Index funds follow holdings made up of several equities and bonds. Consequently, investors get the benefits of diversity, which include raising the portfolio’s projected return while lowering total risk. A single stock may have a sharp decline in price, but if it makes up a tiny portion of a broader index, the damage won’t be as great.
What is the Expense of Investing in an Index Fund?
There are several index funds with no entry minimums. Low yearly costs are another characteristic of index funds, and these fees have been typically decreasing over the last several years. The Investment Company Institute estimates that in 2024, the average charge for an index fund will be 0.05%; some index funds have even lower expense ratios. If everything else is equal, you may choose to select the less expensive fund among those that similarly follow the same index.
Do New Investors Do Well with Index Funds?
For novices venturing into the world of investing, index funds may be a great choice. They are a straightforward, affordable approach to own a variety of equities or bonds that are diversified by imitating a certain benchmark index. Compared to most actively managed funds, index funds have lower cost ratios and often beat them. These factors make them a good option for many seasoned investors in addition to novices.3. One last benefit for recent investors: Your fund will get a lot of news coverage if it is linked to a top index such as the S&P 500 or Nasdaq composite. This will help you stay informed about your investment while gaining insight into the ups and downs of the larger market.
Are Stocks Safer Than Index Funds?
Because index funds are naturally diversified, they are often safer than individual equities. They have a wide variety of companies from different industries since they follow a certain market index, such the S&P 500. You suffer if a single firm that makes up a significant portion of your portfolio underperforms. However, if it’s the S&P 500 index, your index fund has hundreds of them.13
Which Index Funds Are the Best for Retirement?
The top index funds for retirement provide the opportunity for growth together with sound risk management based on your risk tolerance and time to retirement. Broad-market stock index funds, such as the Fidelity 500 Index Fund (FXAIX) or the Vanguard Total Stock Market Index Fund (VTSAX), are good options for long-term gain. Bond index funds such as the Fidelity Total Bond Fund (FTBFX) might be a decent option if you’re looking for income and diversity. Although they are actively managed and invest in a variety of indices and other assets, target-date retirement funds, which automatically modify their allocation as your retirement approaches, may also be a practical alternative for retirement planning.
