Investing in index funds has long been considered one of the smartest investment moves you can make. Index funds are affordable, enable diversification, and tend to generate attractive returns over time. Historically, index funds outperform other types of funds that are actively managed by top investment firms.
An index fund is a type of mutual fund or exchange-traded fund (ETF) -- a bundle of securities that collectively track the performance of a market index such as the S&P 500 (SNPINDEX:^GSPC). An index fund contains the same investments in approximately the same proportion as the index the fund tracks. The index itself is usually focused on a specific sector, geography, or stock exchange.
In 2007, Warren Buffett made a $1 million bet that an index fund would beat the returns of an actively managed hedge fund over 10 years -- and he won in a landslide.
Buffett's victory may be reason enough for some investors to start adding index funds to their portfolios. If you need more convincing, read on to understand what index funds are and why they are so popular.
Benefits of index funds
Index funds enable broad diversification, have low costs, and provide attractive returns. Learn more about these key benefits:
1. Broad diversification
The most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing the likelihood of losing some or all your money.
Consider an index fund that tracks the S&P 500. This index fund would hold about 500 different stocks. While the performance of each of these 500 stocks fluctuates over time, investing in a fund that holds all of them matches your portfolio's performance to that of the index itself. Diversifying your portfolio among so many companies, by investing money into just one index fund, ensures that the value of your portfolio is not overly correlated with the fortunes of any one company listed in the index.
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2. Low costs
Another major benefit of investing in index funds is that the costs, including taxes and management fees, may be lower than those associated with other types of investment funds.
Low management fees: The first cost to consider is the management fee each fund manager annually collects. The amount of the fee, which varies based on the value of your holdings, is determined by the fund's expense ratio. If you hold $1,000 in a mutual fund with a 1% expense ratio, for example, you would pay $10 as the management fee.
Actively managed mutual funds have expense ratios that often range between 1% and 2%. Most of that fee pays for portfolio managers to make buy-and-sell decisions in an attempt to outperform the overall market.
Index funds, by contrast, are passively managed. Since they simply track an index by buying and holding all of the stocks in that index, the holdings of the index fund rarely change. The expense ratio is comparatively low because there's little work required of the index fund's manager.
Index funds' expense ratios typically range between 0.05% and 0.07%, and some index funds have expense ratios as low as 0%. If you hold $1,000 in index fund with a 0.05% expense ratio, then you would pay just $0.50 as the management fee.
Lower turnover ratio
The turnover ratio measures the percentage of a fund's holdings replaced in a single year. For example, if a fund invests in 100 stocks and 10 are swapped out this year, then the turnover ratio is 10%.
Naturally, index funds have a lower turnover ratio than actively managed funds. Index fund turnover ratios are usually about 1% to 2% per year, compared to 20% or higher for some actively managed mutual funds.
Lower taxes on capital gains
If a fund sells a stock for profit, then the difference between the initial purchase price and the final sale price is considered a capital gain. Funds with higher turnover ratios accrue capital gains more frequently, which results in more taxes owed by the fund's investors.
This isn't as much of a concern with index funds, though, thanks to their low turnover ratios. Since fund managers aren't selling stocks all the time, there aren't often capital gains to pass through to shareholders.
3. Attractive returns
As Buffett knew when he made his $1 million bet, even the smartest and most diligent portfolio managers can rarely steer actively managed funds to beat index funds. Only about 23% of actively managed mutual funds outperform the S&P 500 over five years, according to research by Standard & Poor's. Other studies support this number as well.
Individual companies both outperform and underperform the market, but, in general, the overall stock market increases in value over time. As a result, index funds yield generally high returns for low cost, which make them an excellent value for any investor.
How to start investing in index funds
You can purchase index funds through a brokerage firm or a mutual fund company such as Fidelity Investments or Vanguard. Your first step is to look at the index funds' offerings and whether the funds have investment or account minimums.
If you don't plan to invest much money initially, prioritize funds that don't have account minimums. Alternatively, you can get started with an ETF version of an index fund instead of a typical mutual fund, which is more likely to have a high minimum investment.The minimum purchase for an ETF is never more than one share.
Then, choose an index. The S&P 500 and the Dow Jones Industrial Average (DJIA) (DJINDICES:^DJI) are two of the best-known indexes for U.S. stocks, and index funds that track them are a good choice for beginning investors. But there are many more options. Look at how various index funds have performed historically. You should also check their expense ratios and compare them to other funds tracking the same or similar indexes.
Whether you're new to investing or already experienced, an index fund is a great asset to add to your portfolio. It takes a little time to find the right index fund for you, but once you do, you can sit back and let your money grow.
Related index funds topics
How to Invest Money: A Step-by-Step GuideBefore you put down your hard-earned cash, consider your investment style.
How to Invest in Index Funds in 2024Index funds track a particular index and can be a good way to invest. Get a fast introduction to index funds here.
ETF vs. Index Fund: What Are the Differences?Your investment style can dictate which kind of fund is best for your portfolio.
Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
FAQs
Index funds have lower expense ratios than most actively managed funds, making them affordable, and often outperform them, too. These reasons make them a solid choice not only for beginners, but many expert investors as well.
What are 3 advantages to index fund investing? ›
Built-in benefits of index funds
- Lower risk through broader diversification. Each index fund contains a preselected collection of hundreds or thousands of stocks, bonds, or sometimes both. ...
- Lower taxes. Index funds don't change their stock or bond holdings as often as actively managed funds. ...
- Lower costs.
Index funds have lower expense ratios than most actively managed funds, making them affordable, and often outperform them, too. These reasons make them a solid choice not only for beginners, but many expert investors as well.
What are 3 advantages and 3 disadvantages of investing in mutual funds rather than stocks or bonds directly? ›
Mutual funds come with many advantages, such as advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
Why would I want to invest in an S&P 500 index fund? ›
Investing in an S&P 500 fund can instantly diversify your portfolio and is generally considered less risky. S&P 500 index funds or ETFs will track the performance of the S&P 500, which means when the S&P 500 does well, your investment will, too.
What are index funds pros and cons? ›
Index funds tend to offer investors lower costs and taxes than some other types of funds. They're also relatively lower maintenance. One drawback could be that investors cannot pick and choose individual investments that comprise an index fund.
Do billionaires invest in index funds? ›
Warren Buffett might be the world's most famous investor, and he frequently touts the benefits of investing in low-cost index funds. In fact, he's instructed the trustee of his estate to invest in index funds.
Why don't people just invest in index funds? ›
Index investing does not allow for advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock.
Why index funds are better than mutual funds? ›
Index funds are generally suitable for risk-averse investors because of their diversified nature and lower volatility. Conversely, with their active management, mutual funds can be more volatile but also offer the potential for higher returns, making them suitable for risk-tolerant investors.
Do index funds beat the market? ›
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
Tracking error may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc. This is a major risk in index funds. Index funds do lose out on the expertise of the fund manager and the structured investment approach that an active fund manager brings.
What are the pros and cons of investing in funds? ›
Mutual funds allow investors to dollar-cost average over time and reinvest dividends, enabling compound growth. However, taxes on capital gains distributions and dividends can make them less tax-efficient. While mutual funds provide diversification, they still carry market risk based on the underlying securities.
Why are mutual funds a rip-off? ›
However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end, and back-end load charges, lack of control over investment decisions, and diluted returns.
Why would an investor choose an index fund? ›
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification.
What if I invested $1,000 in S&P 500 10 years ago? ›
So imagine you put $1,000 into either fund 10 years ago. You'd be up to roughly $3,282 with VOO or $3,302 from SPY.
Why does Warren Buffett recommend the S&P 500? ›
Buffett: The Average Person Can't Pick Stocks
It includes 80% of the American equity market. So when you buy the S&P 500, you're essentially investing in the growth of the American economy over time. History shows that's a good bet.
What are the advantages of index? ›
Advantages of Index Funds
The main advantage is, since they merely track stock indexes, they are passively managed. The fees on these index funds are low because there is no active management. Exchange traded funds (ETFs) are often index funds, and they generally offer the lowest fees of all.
What are the three advantages of index numbers? ›
The primary role of index numbers is to simplify otherwise complicated comparisons. It is especially useful when comparing currencies that have lots of different nominal values. Some countries even use index numbers to modify public policy, such as adjusting government benefits for inflation.
What are the pros and cons of index trading? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
What are index funds and what are their benefits? ›
The index fund ensures that it invests in all the securities that the index tracks. While an actively managed mutual fund endeavors to outperform its underlying benchmark, an index fund, being passively managed, tries to match the returns offered by the underlying index.
