Index Fund Investing
An index fund is a mutual fund or ETF that tries to match the performance of a market index, such as the S&P 500 or a total U.S. stock market index, rather than beat it. The fund simply holds the stocks in the index, or a representative sample, in roughly the same proportions.
Why investors use index funds
- Low costs. Tracking an index needs no team of stock pickers, so index funds tend to have lower expense ratios than actively managed funds. Fees come straight out of your return every year, so lower costs leave more of the market's return for you.
- Broad diversification. One fund can hold hundreds or thousands of companies, which limits the damage any single company can do.
- Transparency. You know what the fund owns because the index rules are published.
- Tax efficiency. Index funds tend to trade less than active funds, which can mean fewer taxable capital gains distributions.
- Simplicity. A handful of index funds can make up a complete portfolio.
The limits
An index fund will never beat its index; after fees it will trail it slightly. It also offers no protection in a falling market. When the index drops, the fund drops with it. Market-value-weighted indexes put more money into the largest companies, so a fund can become concentrated in a few giants when they grow quickly. And "index fund" covers a lot of ground: a fund that tracks a narrow sector or a complex strategy can be far riskier than a broad market fund.
Choosing an index fund
- Pick the index. Decide what part of the market you want: total U.S. stocks, large companies, international stocks, bonds, or a mix.
- Compare expense ratios. Funds that track the same index can charge very different fees.
- Check tracking. Look at how closely the fund's returns have matched its index over time.
- Look at size and trading. Larger, heavily traded funds usually have tighter spreads and lower risk of closing.
- Decide between ETF and mutual fund. See Stocks vs ETFs vs Mutual Funds for the differences.
A simple approach
Many long-term investors combine a broad U.S. stock index fund, an international stock index fund and a bond index fund in proportions that match their time horizon and risk tolerance, then rebalance once in a while. Target-date funds package a similar mix into a single fund that grows more conservative as a chosen retirement year approaches.