Investing in index funds has become increasingly popular in recent years. Investment research firm Morningstar reported in August 2021 that US stock index funds held $884 billion more in assets than active funds—and they continue to gain market share. Investing in index funds is a hands-off and passive approach that investors use to try and match, rather than beat, the market. Markets tend to rise over time, and index funds seek to capture those gains while holding down fees that tend to eat into returns.
What is an index fund?
“An index fund is a way to invest in every stock within a particular index or grouping,” explains John DeYonker, head of investor relations at Titan. These funds are either mutual funds or exchange-traded funds (ETFs), and their goal is usually to try to match the performance of a benchmark market index. In turn, a market index tracks a certain group of assets, such as stocks or bonds.
For example, the S&P 500 stock market index tracks 500 of the largest publicly traded US companies from leading industries. “You can't technically invest in the S&P 500,” DeYonker says. “That’s why you would need to invest in an index fund.” An S&P 500 index fund tries to mirror the S&P 500 index’s movement.
How do index funds work?
How an index fund works depends on who creates and manages the fund, and whether it’s a mutual fund or ETF. But the basics are often similar.
The fund pools money from investors, and the fund manager uses the money to try and replicate the benchmark index. There are funds for all sorts of market indexes, including stock (i.e., equity) indexes and bond indexes.
Index funds use a passive investment approach, meaning they simply try to mirror the changes in the chosen benchmark. Assets may be invested in the stocks and bonds that the benchmark tracks—or in a representative sample—and fund managers may buy and sell securities to try and move in tandem with the index.
Key things to know about index funds
- Index funds often have low fees. Many, but not all, index funds have lower fees than actively managed funds.
- There can be tracking errors. Index funds aren’t always able to match their benchmark. When there’s a discrepancy between an index fund and its benchmark index, that’s called a tracking error.
- Index funds can make it easy to invest in the market. By choosing an index fund that mirrors a large stock market index, investors can easily invest in a stock market’s overall performance.
- Index funds mirror the ups and downs. While index fund investing is a popular hands-off approach, it isn’t without risk because it mirrors both the rising and falling price of its benchmarks.
- Index investing can be simpler than picking stocks. For retail investors, using index funds may be an easier option than trying to buy and sell individual stocks or bonds.
Examples of index funds
Fund companies can create index funds to track a variety of benchmarks. These include broad stock market indexes, bond indexes, and indexes that focus on a specific region, industry, or other criteria.
These examples are just a small sample of the many types of index funds available to investors:
- Vanguard Total World Stock Index Fund Investor Shares (VTWSX). A mutual fund that tries to track stock market returns from around the world using the FTSE Global All Cap Index as a benchmark.
- Schwab S&P 500 Index Fund (SWPPX). A mutual fund that tries to track the total return of the S&P 500 index.
- SPDR S&P Dividend ETF (SDY). An ETF that tries to track the S&P High Yield Dividend Aristocrats Index, which looks for companies that consistently increase their dividends over time.
- Fidelity U.S. Sustainability Index Fund (FITLX). A mutual fund based on the MSCI USA ESG Index, which tracks mid- and large-cap companies that rate well on environmental, social, and governance (ESG) metrics.
- Invesco California AMT-Free Municipal Bond ETF (PWZ). A municipal bond ETF that focuses on California municipal bonds that are exempt from the alternative minimum tax, or AMT. It tries to track the ICE BofAML California Long-Term Core Plus Municipal Securities Index.
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