What is an Index Fund and Understanding the Basics

What is an Index Fund and Understanding the Basics

Jack Bogle is most remembered for founding Vanguard and creating the first index fund in 1976. Since then, several index funds have been established and incorporated into many investors’ retirement plans. 

Index funds are an attractive investment because they allow investors to track a segment or most of the financial market. In addition, they can provide diversification to one’s investment portfolio at a low cost.  

Remember, all investments come with some level of risk. This article will explain what an index fund is and the pros and cons of investing in index funds. Use this article as a starting point for your research. Then, add index funds to your investment strategy if they fit in your wealth-building plan. 

What is an Index Fund?

An index fund is a type of mutual fund or Exchange Traded Fund (ETF). The portfolio in an index fund tracks and mimics a specific index of stocks, bonds or another type of investment. The most popular indexes are the Dow Jones Industrial Average (Dow Jones), Standard and Poor 500 (S&P 500), and Nasdaq. 

Since an index mimics a financial market, the S&P 500 index tracks and buys all the stocks of 500 U.S. companies in the index. On the other hand, the Dow Jones index is an index of just 30 large U.S. stocks. You’ll find index funds in retirement accounts like 401(k) and individual retirement accounts (IRA).  

Types of Index Funds

There are several types of index funds available. Below is a list of some often seen in the market. 

Broad Market Index Funds: These index funds invest in stocks, bonds or any other type of security. The goal of these funds is to invest in most of the market. That’s why they tend to have the broadest and most diverse collection of U.S. stocks. Examples of broad market index funds are the Dow Jones Industrial Average, S&P 500, and Schwab Total Stock Market Index Fund (SWTSX).

Global/International Index Funds: The world market is larger than just U.S. companies and stocks. Therefore, global and international index funds invest in the stocks of the largest companies in the world. Broad market index funds are limited to U.S. companies. However, global indices include stocks from all over the world, while international indices exclude U.S.-based companies. Examples of these indices include the Vanguard FTSE All-World ex-US Index Fund (VFWIX) and Schwab Emerging Markets Equity ETF (SCHE). 

Market Capitalization: Index funds based on market capitalization track small and mid-sized companies. Smaller companies have the potential to outperform larger ones but can also experience greater volatility. Smaller companies have a higher chance of failing but when they do well their growth is profitable for investors. Examples of market capitalization index funds include Fidelity Mid Cap Index Fund (FSMDX) and iShares Morningstar Small-Cap (JKJ). 

Sector Specific: Sector index funds invest in specific markets like utilities, real estate or technology, for example. Think of an industry and they can create an index for it. It’s that simple. Examples of sector-specific index funds are the Utilities Select Sector SPDR Fund (XLU) and Vanguard Consumer Discretionary Index Fund (VCDAX).

Municipal Bonds: Municipal bonds are an attractive investment because they are exempt from federal income taxes and sometimes state and local taxes, too, if the investor lives in the same state where the bonds were issued. However, buying individual bonds can be time-consuming and risky. So, a good alternative is investing in municipal bond funds and indexes. Examples of municipal bond indexes include iShares National Muni Bond ETF (MUB) and Invesco California AMT-Free Municipal Bond ETF (PWZ). 

Best Index Funds in 2022

According to Bankrate.com, the best index funds in 2022 are two mutual funds and three ETFs:

1. Fidelity ZERO Large Cap Index (FNILX)
2. Vanguard S&P 500 ETF (VOO) 
3. SPDR S&P 500 ETF Trust (SPY)
4. iShares Core S&P 500 ETF (IVV)
5. Schwab S&P 500 Index Fund (SWPPX)

Fidelity ZERO Large Cap Index: This index was designed to replicate the S&P 500 and tracks the largest 500 U.S. companies. However, it does not include the S&P name because that would require Fidelity to pay a licensing fee to S&P for the use of their name. Fidelity markets this index as a “Zero” fund because it costs investors zero dollars to invest in this index fund. 

Vanguard S&P 500 ETF: This index tracks the S&P 500 and is currently one of the largest funds on the market. The portfolio’s largest holdings are in stocks for Microsoft, Apple, Amazon, Alphabet Inc., Facebook, Johnson & Johnson, and more. The costs are also very low. At the time of this article, it cost $3 annually for every $10,000 invested.

SPDR S&P 500 ETF Trust: This index tracks the S&P 500 and is one of the oldest ETFs since it was established in 1993. With $374 billion in assets, this is a popular fund. At the time of this article, it would cost you $9 a year for every $10,000 invested. 

iShares Core S&P 500 ETF: BlackRock is the financial powerhouse behind this fund. The fund has $185 billion in assets and also tracks the S&P 500. At the time of this article, it would cost you $3 a year for every $10,000 invested. 

Schwab S&P 500 Index Fund: Charles Schwab launched this fund in 1997. Today, it has $61.4 billion in assets and a low expense ratio of 0.02 percent. This means for every $10,000 invested it would cost you $2 a year. Just like other S&P funds, it tracks the top 500 U.S. companies. 

Why Should You Invest in Index Funds?

Index funds are not actively managed by a fund manager that is choosing specific stocks and aiming to profit from accurately predicting when to buy and sell stocks in the market. Because someone is not actively managing index funds, they have lower expenses, which is a cost-savings to the investor. They also incur fewer taxes than actively managed funds. 

Index funds are also attractive to investors because they offer diversification. Instead of investing in one company’s stock, you can spread your investment dollars across several companies and sectors. This ensures you spread out your risk, too. 

However, there is not much flexibility with index funds. The fund is based on the sector it’s mirroring. So if you want to add a particular company to your mix you cannot. Also, if you invest in more than one index fund, you might overlap in the same categories since some indexes invest in the same companies or sectors. Yet, for long term investors, an index fund can be the perfect investment since it offers broad market exposure, low fees and low portfolio turnover. 

Where Do I Buy Index Funds?

You can purchase shares of an index fund from a mutual fund company or a brokerage firm such as Vanguard, Charles Schwab or ETrade. When doing your research, take into consideration the expenses charged (including trading fees), what index your fund tracks and the diversification of the index fund. 

You can also look up most funds and what they include through websites like Bankrate, Morning Star, Market Watch and Yahoo Finance. Most of these sites will not only share the latest cost for shares in an index fund, but they may also discuss performance and rankings, too. 

You can also work directly with companies that offer robo advisors or hire a financial advisor to help you invest your money. 

Final Thoughts

If you are looking for an investment where you can deposit money and let the market do the rest, invest in index funds. You can choose your specific sector and decide if you want to invest in the international markets or limit yourself to the United States. Whatever you choose, you don’t have to monitor the funds daily. You can check on their performance quarterly or once a year. Just make sure to review fees and decide if this is going to be your long term investment or something for the short term. As mentioned before, index funds are better suited for long term investments. 

Remember, there is more than one way to build wealth. So, if you decide index funds are not for you, that’s ok. You can decide to invest in real estate, precious minerals, businesses and more. Get educated about your finances, decide to save and make a plan for how you want to build wealth. You can establish a plan that includes investing, income from your job or side hustles, just to name a few. Stick to your plan, remain disciplined and be patient. Rome wasn’t built in a day and very few people have managed to become millionaires overnight. 

Acquania Escarne is the creator of The Purpose of Money, a community of women building generational wealth for their families one dollar at a time. As an entrepreneur, real estate investor, and licensed insurance agent, Acquania has always been passionate about financial literacy. On her website, Acquania blogs about ways to help you improve your money habits, create wealth, and invest in real estate. Follow Acquania on social media for daily tips.

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Published at Wed, 16 Feb 2022 03:00:00 -0800