What Are Index Funds and How Do They Work?

If you want to start investing, it can feel overwhelming at first. There are lots of unfamiliar terms, and sometimes, it feels like the finance world makes it intentionally hard. Luckily, there's a very straightforward way to invest in a wide variety of stocks: index funds. 

What is an index?

In the finance world, an “index” is a list of companies that share a common characteristic. This could be their size, the sector they're in, or even whether or not they pay dividends. You can group stocks together in a variety of ways to create an index. The point of an index is to track how a particular market segment is performing as a whole.

There are market indexes for all kinds of purposes. The S&P 500 tracks the 500 biggest companies, but there are also index funds that track the top 100, or only small companies, or only companies that pay dividends, or only companies in a specific sector. If you can think of a way to categorize stocks, there's probably an index for it!

For example, the Dow Jones Sustainability Index tracks companies that focus on sustainability in their business practices.

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What are index funds?

An index fund contains several different companies in one fund. It’s like buying a basket of assorted fruit instead of one apple. The basket, in this case, is the index fund, and the shares of companies that are in that fund will closely mimic the index they follow. 

A well-known index fund is the S&P 500. This is an index, or a list, of the largest 500 companies in the United States.

If you wanted to create a portfolio of every stock listed on the S&P 500 index, it would be a lengthy and difficult process. You'd have to buy the individual stocks of 500 companies, and keep them weighted as percentages of the whole, to mimic this index. Plus you'd have to update your portfolio holdings daily to keep everything in line.

If that sounds pretty complicated to you, buying index fund is a great way to avoid that time-consuming process!

When you invest in an S&P 500 index fund, a computer will do all that complicated math for you.

How do index funds work?

The index fund “basket” holds a representative sample of the index it follows. This means the index fund won’t have exactly 500 shares to match the companies in the S&P 500, but rather a ratio of shares depending on the size and performance of the companies.

The index fund aims to follow the underlying index as closely as possible, and it won't track it perfectly, but it'll be pretty close. Index funds invest in the companies that the index tracks and will make changes as the companies in the index fund change. For example, if a company drops off the S&P 500 index, the fund would sell the stock of that company and buy the stock of a company that replaced it.

The benefit of purchasing an index fund is that it’s a more conservative way to invest because of its diversity. If one company performs poorly, there are still numerous companies in the fund that will be doing well. However, if you purchased only Apple stock in your portfolio, your investments would rise or tank depending on how the single company performs.

Index funds help keep the fund balanced and your money more insulated from one company’s performance…or lack thereof!

Related: How To Start Investing

Pros of index funds

Whether you’re just starting out in the market or have been buying and trading for years, index funds are a great addition to many investing portfolios.

Lower costs

The biggest perk with index funds is that they are a low-cost investment item. Typically, when you own a mutual fund, exchange-traded fund, or index fund, there is an ongoing fee involved called an expense ratio. This is the cost of owning the fund and pays for expenses like a fund manager. However, the fees for index funds are low in comparison since they are passively managed.

Mutual funds are very similar to index funds except they are often actively managed by a fund manager. Therefore, the fees they charge are higher since a manager needs to make the investing decisions.

Diversification

Index funds are a diversified investment option. Instead of purchasing a single stock, like Disney stock, Tesla stock, or Apple stock, you can purchase a broad market index fund. The risk is spread out among many companies, making your investment inherently less risky overall.

You can even buy an index fund that tracks the market as a whole. So you're actually invested in every public company in the US — or even the world! This makes for a very well-diversified portfolio.

Easy to buy and sell

There are many different brokerages that offer index funds. While some of them might have a minimum investment required to open an account, others don't. It's possible to get started buying index funds with very little money, and you can typically place buy and sell orders that take place the same day or the next day.

Cons of index funds 

While index funds are a great choice for many investors, it’s worth noting that there are a few drawbacks to investing in index funds.

No active management

Index funds are considered a passive management investing option. While different experiments have shown that an index fund can perform just as well, if not better, than an actively managed mutual fund, many people believe that specific managers can outperform the market. 

With passive management, there is no fund manager to address a changing market landscape. If that is important to you, then index fund investing might not be the best option.

All or none 

When you invest in index funds, you don't have a choice over customizing the companies that are inside of your index fund account. You either choose to buy them all or buy none.

A complaint against index funds is that larger companies, with a larger market capitalization, have more influence on an index than smaller companies. As of this writing, Apple, Microsoft, and Nvidia make up more than 20% of the S&P 500 index. They certainly have an outsized impact on the performance of the index fund!

Costs associated with index funds

The two main costs associated with index funds are expense ratios and transaction costs. The expense ratio covers the costs of managing the fund, like administrative costs.

According to the Investment Company Institute, the expense ratio for mutual funds that are actively managed is, on average, 0.68%. Index funds, which are passively managed, have an expense ratio of only 0.06% on average. The difference adds up considerably when you calculate investments over a long period of time!

Transaction costs include items like brokerage commissions when you purchase the fund. Many low-cost brokerage funds offer $0 transaction fees, which means $0 per trade. Other online brokerages might charge between $3 and $7 per trade.

Related: What are ETFs?

Where to buy index funds

If you’re ready to take the leap on investing in index funds, the next step is figuring out where to get them, and you have a few different options.

Employer-sponsored retirement plans

If you have a 401(k) through your job, check to see if your plan has index funds as an investing option. Unfortunately, you don’t always get to choose which funds your employer offers, so check with HR or a trusted advisor if you're unsure how to select funds for your plan.

Brokerage companies

A brokerage company is a company that purchases index funds on your behalf. There are several popular discount brokerage firms that offer reduced or no commissions. Webull is a particularly good choice for beginner-investors because it has a user-friendly interface and has been around for years. Plus, the good news is that for many of these low-cost brokerage firms, you don’t need to have a large amount of money to open an account with them.

Robo advisors

Robo-advisors are sophisticated online software that allows consumers to automate their investing. With robo-advisors, you put in your risk tolerance and financial goal, and an algorithm automates the investing process for you.

Financial advisors

You also have the option of working with a financial advisor. Look for a financial advisor with a Certified Financial Planner designation, as they must meet high standards for certification.

FAQs

Are index funds good for beginners?

Since they have low management fees and offer a lot of diversification, index funds make for a very easy investment and are perfect for beginners. If you're unsure where to get started, look for total market index funds, which track the stock market as a whole.

Can I invest $100 in index funds?

Yes! You just need to find a brokerage account that has a low minimum investment.

Do index funds make money?

Index funds invest in the stock market, and over the long term, the stock market does make money. No returns are ever guaranteed and returns will vary from year to year. As a general rule, you shouldn't invest money that you'll need within the next five years. 

Want to learn more about investing? Start here!

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