Updated January 20, 2020

How Do Index Funds Work?

Stocks

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As investors, it’s important to understand some of the different types of investment strategies. This way, we can make educated decisions before we begin investing our hard-earned money. In this article, we’re going to dive into the topic of index funds, explaining how index funds work and why they may benefit both advanced and novice investors.

First off, let’s start with the basics.

Investment management comes down to two primary investment strategies:

  1. Active management
  2. Passive management

What Is Active Investment Management?

Active investment management is an investment strategy where an investor actively or routinely invests their money. There’s a wide variety of investment styles that may be considered active.

Here are a few examples:

Active investing involves the investor making investment decisions on their own based on their intuition or skill.

They aim to take advantage of market irregularities or inefficiencies in pricing. This way, they can profit once the market adjusts and correctly prices the security.

The overall goal of active investment management is to beat the market.

What does this mean?

There’s no point in putting in a great amount of effort into active investments if you aren’t going to earn returns above the market itself.

For example, say the S&P 500 returns 10% in a given year. It’s pointless to choose an active investment strategy that earns 8% in the same year. A passive index fund that followed the S&P 500 would have given you a higher return for less work.

One of the best active investors of all time is Warren Buffett. He has one of the best track records over the last 50 years. Even though Buffett doesn’t trade securities every day – and often he’ll hold a position for years or even decades – he’s still an active investor. His goal is to earn returns above the market and to profit on market pricing inefficiencies.

What Is Passive Investment Management?

Passive investment management is the act of investing in a portfolio or group of stocks or bonds tied to an index or benchmark.

Passive investing doesn’t rely on the skill or intuition of the investor. Rather, the goal of passive investing is to earn returns equal to a benchmark or index. In many ways, this means earning returns equal to the market.

A passive investment strategy inherently holds the belief that the stock market rises over long periods of time. And investors can take advantage of this long-term growth by investing in low-cost diversified index funds.

Most of the time, passive investors have a buy-and-hold strategy. This means they’re buying index funds over time. They aren’t making frequent buys and sells of securities. This way, they aren’t incurring excessive trading fees or trying to tactically time the market.

Over the last 30 years, passive investing has dramatically risen in popularity. Investors are beginning to understand how difficult it is to use an active investment strategy and consistently beat the market over time.

What Are Index Funds?

One of the most common passive investment strategies is to invest in index funds.

Index funds are pools of securities tied to a benchmark or market index. They allow investors to invest in a pool of securities and gain diversified exposure to different parts of the stock or bond market.

One of the most beneficial characteristics of index funds is the low fee structure. This is due to the relatively low operating expenses of a passive fund compared to an active fund, which will typically have large teams of investment managers and analysts.

Another characteristic of index funds is low portfolio turnover, which means the holdings within the fund are rarely and not frequently changed.

Before the invention of index funds, it was extremely difficult to buy the market as a whole without having a significant amount of funds and resources.

For example, to buy the S&P 500 before the index fund was created you would have had to buy 500 individual stocks.

This type of broad market investing was limited to wealthy individuals who had access to stockbrokers and enough capital to buy large amounts of individual securities.

With the invention of index funds by Vanguard and Jack Bogle, broad market diversified investing was made available to everyday investors.

How Do Index Funds Work?

Index funds are built with the goal of providing diversified exposure to both specific and/or broad markets.

These market indexes are constructed based on certain characteristics or traits of stocks or bonds.

You could buy index funds based on regions, sectors, market capitalization, and many other factors. For example, the S&P 500 is an index containing 500 of the largest companies listed on U.S. stock exchanges. The Barclays Aggregate Bond Index is a bond index holding 17,000 intermediate-term bonds traded in the United States.

What Is Diversification?

Diversification is the principal and most advantageous characteristic of index funds.

Most investors understand the potential benefits of diversification, but let’s explain exactly why diversification is important.

If I invest my entire portfolio in one stock, I’ll have significant risk and portfolio volatility all subject to the fluctuation of that single company.

However, if I invest in a pool of five stocks, the volatility of each stock – especially if they are uncorrelated – has the ability to cancel each other out.

Correlation is extremely important because, if you are holding five technology stocks, they’ll tend to be correlated and move in similar directions. This means your portfolio will be highly concentrated in technology and subject to the price fluctuations within that sector.

Rather, if you held a portfolio of five stocks all within different uncorrelated sectors, you’d have a better chance of creating portfolio diversification and decreasing your overall portfolio volatility.

Investors can build portfolios with multiple or a variety of index funds in order to increase diversification and gain exposure to different sectors or regions.

If you like technology, you could buy a technology index fund with a portion of your portfolio. If you think the European bond market shows promise, then you could buy a European bond index fund.

How to Buy Index Funds

Investors can gain exposure to market indexes by purchasing index funds with ETFs or mutual funds.

One of the most valuable benefits of index funds is the low cost to hold them.

Most funds have holding fees called expense ratios. These are fees involved with managing and operating the fund itself. Many times, investment advisors and fund managers will earn fees for operating the fund.

Index funds are slightly different since there’s not nearly as much fund management and ongoing trading within the fund. This allows for the expense ratios of index funds to be lower compared to active funds.

Index fund exchange-traded funds (ETFs) and mutual funds are investment vehicles where investors can purchase shares and gain exposure to index funds. These are slightly different fund structures, but both have similar characteristics and strategies.

Often, mutual funds may have upfront fees for purchasing the fund called load. However, this is a more common characteristic in active management mutual funds.

Robo-advisors such as Betterment are a great and easy way to invest in index funds. These advisors’ computer algorithms can custom-tailor a portfolio to match your needs and risk tolerance.

Dollar Cost Averaging

Most investors who purchase index funds use a strategy called dollar cost averaging.

This is a strategy where an investor will make small purchases of an investment over time, rather than all in one shot.

For example, say you have $10,000 to invest. You could dollar cost average into the market and invest $2,000 per month over five months. This, way you’re reducing the risk of entering the market in overheating or poor conditions.

Another strategy for dollar cost averaging is to make a deposit to your account each month and invest the funds. Many investors who fund retirement accounts use this method. Over time, they’ll dollar cost average their monthly, semi-annual, or annual contributions.

This way, they’re investing small sums over time, rather than saving up a significant amount of cash and entering into the market all in one shot.

Dollar cost averaging is just another way to reduce risk while investing, however, it can sometimes work against you.

Pros of Investing in Index Funds

Low fees: Index funds are some of the cheapest ways to purchase diversified groups of stocks and bonds within a portfolio. Many index funds have extremely low expense ratios, especially compared to active funds. For example, Fidelity is now offering 0% expense ratio index funds.

Diversification: When investing in an index fund, it’s extremely easy to diversify your portfolio. Investors can choose index funds that are more concentrated in a sector or region, or they can purchase broad market funds gaining exposure to an entire market. Diversification is one of the biggest benefits of investing in index funds.

Passive: Most active investors spend hours, days, or even weeks in an effort to find the best investments for their portfolio. Index funds, on the other hand, don’t require as much research, and once you have your portfolio allocated to your desired funds, you can passively invest your money. This makes investing much more of a long-term approach, rather than trying to benefit from short-term price fluctuations.

Market returns: Investors can invest in a broad market index and earn returns equal to the market. This is a very valuable feature.

According to Jack Bogle, the founder of Vanguard, over 95% of active funds don’t beat the market in a given year. And less than 1% of active funds can beat the market in consecutive years. This shows how difficult active investing can be and how earning market returns over time can be an extremely valuable strategy.

Cons of Investing in Index Funds

Lack of control: Investing in index funds gives you less control of individual investments when compared to active funds. You’re not choosing individual stocks or bonds; rather, you’re choosing which markets, sectors, or regions you’d like to hold within your portfolio.
In essence, you’re giving up control to the index fund managers.

Index funds rarely change holdings, but when they do, the index managers are deciding which stocks or bonds to keep within the index. Most of the time, this is a calculated procedure, but there can also be human elements to managing an index.

Limited investments: There’s a wide variety of index funds available to investors, and even more being created every day. However, index funds don’t encompass every sector, region, or market around the world.

There are still limitations on certain markets where index funds can’t reach. Investors who choose to invest in index funds may be limited to certain investments, rather than choosing their own stocks and bonds.

Passive investing isn’t for everyone: When investors decide to invest in index funds, they’re deciding to pursue a passive investment strategy.

If you’re an investor who enjoys researching and finding individual stocks and bonds, index funds may not be the ideal strategy for you. Index funds aren’t for everyone. And as index funds become a more popular investment strategy, the odds of success for active management inherently increases.

Index Funds in Summary

After Vanguard pioneered the invention of index funds in the late 1970s, low-cost diversified investing has been made available to everyday investors.

Index funds provide an easy way for investors to gain broad market exposure within their portfolios and keep costs down at the same time.

Index funds have created a shift in dynamic in the overall investing community. Whether you’re a new investor or a seasoned veteran, index funds may have benefits available to you.

This article is written for educational purposes and not to provide investment recommendations or financial advice.

Ed Canty

Ed Canty is a personal finance enthusiast. At his blog, investingsimple.com, he covers investing, budgeting, taxes, and many other topics. At his day job, Ed works as a financial planner helping clients navigate their financial needs. Ed is currently attending Northwestern University to pursue the CERTIFIED FINANCIAL PLANNER™ certification.

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