You don’t have to be a pro to build wealth in the stock market. In fact, index funds are a popular asset class that takes much of the work involved in investing off the table.
Perhaps that’s why Warren Buffett believes they’re the perfect investment for most investors.
These funds provide low-cost, diversified access to gains without significant research requirements or market experience. But what exactly is an index fund, and are they really as great as Buffett says they are?
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of an underlying benchmark index.
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These funds collect investments from a large group of investors and use their investment dollars according to the fund’s prospectus. This document outlines the fund’s objectives, the market index that the index fund tracks, and how the fund manager plans to achieve the fund’s investment objectives.
Index fund investors share in price appreciation and dividends generated from the fund’s investments based on the number of shares they own.
For example, one of the most popular index funds on the market is the Vanguard Total Stock Market Index Fund. The fund tracks the CRSP U.S. Total Market Index, achieving results by purchasing shares in stocks listed on the index. Vanguard investors who own shares of the fund experience gains when the benchmark is trending up and declines when it’s trending down.
Moreover, when stocks listed on the benchmark index pay dividends, those dividends are split up and paid to the fund’s investors based on the number of shares they own.
How Index Funds Work
Index funds are very similar to other types of mutual funds and ETFs. They all accept investments from a large group of inventors, invest according to the details of their prospectuses, and share gains and dividends with investors.
The difference is how the funds are managed.
Index funds are passive investments, so the fund manager doesn’t use a range of aggressive strategies in an attempt to beat the market. There’s no need for a team of traders and analysts who find and make moves in the market. Instead, fund managers only make moves when the underlying indexes do.
After all, the goal of an index fund is to closely mirror the results of the underlying index it’s centered around. This is generally done by investing in each stock listed on the index with the same weighting the index uses.
The lack of legwork required for the fund manager is a big advantage for the investor too. Index funds have significantly lower expense ratios than their actively managed counterparts. When you invest in index funds, you get to hold onto more of your gains.
What Indexes Do Index Funds Track?
The popularity of index funds has led fund managers to create funds that track just about any benchmark index you can think of.
The most popular benchmark is the S&P 500. The S&P 500 is made up of the 500 largest U.S. stocks by market capitalization and is largely regarded as the flagship benchmark for the U.S. stock market.
Other popular benchmark indexes for index funds include:
- Bloomberg U.S. Aggregate Bond Index. The Bloomberg U.S. Aggregate Bond Index is one of the most popular benchmarks for bond index funds. The index is designed to track the performance of U.S. dollar-denominated investment-grade taxable bonds.
- Dow Jones Industrial Average. The Dow Jones Industrial Average (DJI) is a large-cap index made up of 30 of the largest, most prominent U.S. companies. DJIA funds attract investors who are interested in investing in market leaders that pay dividends.
- Nasdaq Composite Index. The Nasdaq Composite index is a highly diversified list of stocks across all sectors. However, the majority of stocks listed on the index are in the tech, biotechnology, and healthcare sectors. As a result, Nasdaq-centric index funds often attract tech and growth investors.
- MSCI EAFE Index. The MSCI EAFE Index is a diversified group of stocks from Europe, Australasia, and the Far East. This index is popular with investors interested in international exposure.
- Russell 2000 Index. The Russell 2000 Index is one of the most diversified groups of small-cap stocks available, so funds that track the index are attractive for investors who want to expand their gains by getting in on the ground floor with their investments.
- Wilshire 5000 Total Market Index. The Wilshire 5000 Total Market Index is one of the most inclusive representations of the large-cap corner of the U.S. stock market. In fact, the benchmark represents more than 80% of the entire United States market cap.
Pros & Cons of Index Funds
Index funds are solid investment options for the right inventors, but they’re not perfect. There are a few pros and cons to consider before getting involved in them. Here are the most significant:
Pros of Index Funds (They’re Great for Passive Investors)
Index funds have become a popular investment vehicle by offering investors several perks. Some of the biggest advantages to investing in these funds include:
- Heavy Diversification. Most index funds are highly diversified groups of stocks. This high level of diversification provides some protection from volatility. When an individual stock or even a small group of stocks in the portfolio takes a dive, gains in other holdings may offset the blow.
- Low-Cost Investing. Index funds are known for low fees. Not only can they get away with lower expense ratios than actively managed funds, but a single investment often represents ownership in hundreds or even thousands of stocks. That cuts down on trading fees.
- Passive Investing. You don’t have to worry about spending hours researching individual stocks when you invest in these funds. Index investing is largely passive, though you should still compare each fund that provides access to a particular index. They’re not all created equally.
- Lower Taxes. Index funds generally hold investments for the long term. They make very few trades that could trigger tax events, so you benefit from lower capital gains taxes when reporting your investment income. There are also other beneficial tax loopholes associated with ETFs.
- Reasonable Returns. Index funds track the performance of the overall market or specific sectors. While not designed to beat the underlying benchmarks, they provide reasonable returns in line with those benchmarks.
Cons of Index Funds
Index funds might seem like the best thing since sliced bread. But even sliced bread has its flaws, and these investments are no different. The biggest drawbacks to investing in index funds include:
- No Chance to Beat the Market. Index funds are highly diversified investments that produce reasonable returns. Just remember that you’re not going to beat the market if you are the market. Index funds’ high level of diversification limits losses but can also limit gains.
- Lack of Control. When you invest in an index fund, you hand control over your investment to the fund manager. The fund manager won’t only be charged with choosing your investments for you, they’ll also vote on your behalf when propositions make their way to shareholder votes. For example, a company considering an acquisition offer will usually hold a shareholder vote to make sure the majority of holders agree with the move.
Is an Index Fund Right for You?
Index funds are great investments for the right investor. So, how do you know if you’re the right investor? Consider your market knowledge, investment objectives, and desire to control your portfolio.
These funds may be the right investment vehicle for you if:
- You’re a Beginner. You can be successful as an index investor with very little market research or experience. This makes index funds the perfect investment vehicle for the beginner investor.
- You’re Busy. Even if you have plenty of market experience, you might not have the time it takes to manage a diversified portfolio of individual stocks. Index funds can be a useful substitute.
- You’re Investing for Retirement. Index funds often comprise the core holdings in 401(k) and IRA portfolios thanks to their long-term time horizon and heavy diversification.
- You’re Risk Averse. If you’re a risk-averse investor, index funds’ heavy diversification will put your mind at ease.
- You Enjoy the Slow & Steady Approach. You won’t get rich quickly investing in index funds, but you will build wealth over time. So, if you’re interested in a slow and steady approach to investing, these funds may be the perfect fit.
How to Invest in Index Funds
Although there’s less work involved in index investing than there is in picking individual stocks, there are still a few steps that you should take to ensure success.
Step #1: Decide which Type of Fund You’re Interested In
Are you interested in growth, income, or value? Would you rather invest in domestic stocks, international stocks, or a mix of the two? It’s important to know what you want to invest in before looking for an investment.
Step #2: Make a Spreadsheet
Use the following titles on the tops of the columns on the spreadsheet: Fund Name, 5-Year Performance, Dividend Yield, Expense Ratio.
Step #3: Fill out the Form
Now, search Google or Yahoo! Finance for funds in the category you’re interested in. For example, if you want income, search “Income Funds.” Use the results to fill out the spreadsheet. Include at least 10 different funds.
Step #4: Compare Your Options
The ultimate goal is to invest in funds that have the strongest historic performance and charge lower fees than their competitors. Use the data in your spreadsheet to find your best options.
Step #5: Make Your Investments
Finally, log into your brokerage account and buy shares of the funds that charge the lowest management fees and produce the best investment outcomes.
Index Fund FAQs
It’s important to ask questions before you invest in anything, including index funds. These are some of the most common questions that come up for would-be index fund investors.
What’s the Difference Between an Index Fund vs. Mutual Fund?
An index fund can be a type of mutual fund or ETF, but mutual funds aren’t always index funds.
There are two types of mutual funds on the market. Those are index mutual funds and actively managed mutual funds.
Index funds take a passive management approach, investing in an attempt to produce returns equal to those generated by the underlying benchmark. Active mutual funds take an active approach to investing, deploying complex strategies in an attempt to beat the returns of their underlying benchmarks.
What Are Index Exchange-Traded Funds (ETFs)?
Index ETFs are index funds that are traded on public stock exchanges like the Nasdaq or New York Stock Exchange (NYSE).
These funds differ from index mutual funds that trade once per day at the close of the market. Instead, they trade freely throughout the trading session on a public exchange.
How Can You Buy Index Funds?
The easiest way to buy an index fund is to purchase shares through your brokerage account. Keep in mind that not all brokers offer access to index mutual funds. If the funds you’re interested in are mutual funds, you may have to make your investment directly through the fund provider.
What Is Indexing?
Indexing is an investment strategy centered around index investing. By building a portfolio of multiple index funds, you tap into various types of stocks and benefit from the risk protection offered by heavy diversification.
Some of the most popular indexing portfolios include the Scott Burns Margarita Portfolio, the Talmud Portfolio, and the Warren Buffett ETF Portfolio.
Do All Index Funds Produce Similar Results?
Different index funds produce different returns. That’s because they’re each managed by different fund managers and track different market indexes. For example, an S&P 500 market index fund will perform differently than a mid-cap index fund.
Moreover, two funds that focus on the same market capitalization and market index may perform differently depending on how they’re managed. For example, a Fidelity index fund might have different performance metrics when compared to a similar index fund managed by Vanguard.
Which Companies Provide the Best Index Funds?
Index funds are the perfect investment vehicle for most investors, as alluded to by Warren Buffett. However, they’re not for everyone. If you’re a beginner or busy investor who’s OK with relinquishing control and taking the slow and steady approach to investing, indexing may be the way to go.
However, if you have plenty of market experience and time to do the research, you might want to consider building a portfolio of individual stocks. That’s especially the case if you’re interested in taking risks to beat the market over the long term.
Higher average returns.
If you're investing for the long term, passive funds of all kinds almost always give higher returns. Over a 20-year period, about 90% index funds tracking companies of all sizes outperformed their active counterparts.
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).Why are index funds considered passive investments? ›
Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a broad market index or indices. Passive investment is cheaper, less complex, and often produces superior after-tax results over medium to long time horizons than actively managed portfolios.What is an index fund and why are they popular? ›
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.Are index funds Good for passive income? ›
Index investing is a form of passive investing
The goal with mutual funds is to beat the market, while the goal with index funds is simply to match the market's performance. Since index funds don't require daily human management, they have lower management costs (called “expense ratios”) than mutual funds.
- Reduce expenses. Passive investing generally costs around 0.20 percent a year in fees, compared to around 1.35 percent for active investing.
- Diversify into index funds. Simply select an index in the asset classes you want to hold. ...
- Minimize taxes. ...
- Exhibit discipline.
ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. In addition, investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds.Who should buy index funds? ›
Typically, index-tied funds are suitable for individuals with a long investment horizon. These funds tend to experience fluctuations in the long term, which usually averages over the long run. So, if you have an investment window of over seven years, you can expect the fund to perform to its full potential.Is an index fund better than a stock? ›
As a general rule, index fund investing is more advantageous than investing in individual stocks, because it keeps costs low, removes the need to constantly study earnings reports from companies, and almost certainly results in being "average," which is far preferable to losing your hard-earned money in a bad ...Is Warren Buffett a passive or active investor? ›
Warren Buffett is the ultimate example of the active investor. He believes in identifying quality stocks with deep value and holding them to eternity (well almost). The focus of Warren Buffet has always been on finding stocks with a solid margin of safety quoting at discounts to their fair value.
- Nippon India Index Fund - Sensex Plan.
- LIC MF Index Fund Sensex.
- ICICI Prudential Nifty Index Fund.
- UTI Nifty Index Fund.
- Franklin India Index Fund Nifty Plan.
Index funds make money by earning a return. They're designed to match the returns of their underlying stock market index, which is diversified enough to avoid major losses and perform well. They are known for outperforming mutual funds, especially once the low fees are taken into consideration.What are the pros and cons of index funds? ›
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 is the most popular index fund? ›
An S&P 500 index fund invests in each of the 500 companies in the S&P 500 (SNPINDEX: ^GSPC). It doesn't try to outperform the index; instead, it uses the index as its benchmark and aims to replicate its performance as closely as possible. S&P 500 funds are by far the most popular type of index fund.What does Warren Buffett think about index funds? ›
Warren Buffett likes index funds — especially those that follow the S&P 500. “In my view, for most people, the best thing is to do is owning the S&P 500 index fund,” he once said.Does Warren Buffett use index funds? ›
Warren Buffett is a firm believer in index funds. In fact, in his 2013 letter to Berkshire Hathaway (BRK. A 0.35%) (BRK. B 0.40%) shareholders, he wrote that his will recommends that most of the cash that goes to his family be put in a low-cost S&P 500 index fund.Is an index fund enough for retirement? ›
For total-return-oriented retirees who are using rebalancing (trimming appreciated securities) to meet living expenses, index funds and ETFs also work well. That's because index funds and ETFs are typically pure plays on a given asset class.How do passive investors make money? ›
- Dividend stocks. ...
- Dividend index funds and exchange-traded funds. ...
- Bonds and bond index funds. ...
- High-yield savings accounts. ...
- Rental properties. ...
- Peer-to-peer lending. ...
- Private equity. ...
According to a 2021 Gallup Investor Optimism Index, 71% of U.S. investors surveyed said passive investing was a better strategy for long-term investors who want the best returns.What are the pros and cons of passive investing? ›
- Pros of Passive Investments. •Likely to perform close to index. •Generally lower fees. ...
- Cons of Passive Investments. •Unlikely to outperform index. ...
- Pros of Active Investments. •Opportunity to outperform index. ...
- Cons of Active Investments. •Potential to underperform index.
Index mutual funds & ETFs
Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
A 401(k) account's major edge over an index fund is the tax advantage. Contributions to 401(k) accounts are pre-tax. Owners don't pay taxes on dollars they put in or the earnings from their investment portfolio until they start withdrawing funds.Is an IRA or index fund better? ›
Mutual funds and index funds are both common Roth IRA investment choices. Both types of investments can help you achieve portfolio diversification. But for many investors, index funds are the better choices because the fees are typically lower.What do you own when you buy an index fund? ›
With an S&P 500 index fund you own the market, instead of trying to beat it. In fact, legendary investor Warren Buffett has long advised investors to buy and hold an S&P 500 index fund. So if you're considering one for your portfolio, here's what you'll need to know to get started.Is it wise to invest in index funds? ›
Moreover, index funds give you a low-cost method to invest. They can also bring you good gains than fund managers do, and aid in your achievement of investment and financial goals. This is great on one hand, but on the other, index funds put a lot of weight on stocks in the large-cap category.How many index funds should I own? ›
A three-fund portfolio is made up of three index funds or ETFs. Advisors typically suggest choosing a total U.S. stock market index fund, an international stock fund and broad market bond fund. The amount of money you allocate to each fund depends on your age, goals and risk tolerance.What is the main disadvantage of index fund? ›
Disadvantages of Index Funds
There are also disadvantages to using index funds for investments. The lack of flexibility limits index funds to well-established investment styles and sectors. Furthermore, stock indexes experienced a great deal of volatility in 2020.
Investing products such as stocks can have much higher returns than savings accounts and CDs. Over time, the Standard & Poor's 500 stock index (S&P 500), has returned about 10 percent annually, though the return can fluctuate greatly in any given year.How much is 100k passive income? ›
An investor with $100,000 can potentially expect anywhere from $1,500 to as much as $12,000 a year on average from passive investments that will require little or no effort to oversee.Where should I invest 30K for passive income? ›
- Stocks & ETFs. Unsurprisingly, one of the best ways to invest $30,000 is to invest in a variety of stocks and exchange-traded funds (ETFs). ...
- Real Estate. ...
- Index Funds. ...
- Mutual Funds. ...
- Cryptocurrency. ...
- Alternative Assets. ...
- Fixed-Income Investments. ...
Vanguard is well-known for its pioneering work in creating and marketing index mutual funds and ETFs to investors. Indexing is a passive investment strategy that seeks to replicate, rather than beat, the performance of some benchmark index such as the S&P 500 or Nasdaq 100.Is BlackRock a passive investor? ›
BlackRock: Passive Investor, Activist Shareholder - WSJ. News Corp is a global, diversified media and information services company focused on creating and distributing authoritative and engaging content and other products and services.Is the S&P 500 passive? ›
Index funds based on the S&P 500 are NOT passive investments. Investment strategies that involve the purchase of index funds are often called “passive” strategies.Do active managers beat index funds? ›
“They are one of the only reliable predictors of success.” Fees are a big reason why index funds typically outperform their actively managed counterparts. The average asset-weighted fee for an index fund was 0.12% in 2020 versus 0.62% for active funds, according to Morningstar.What is the most secure index fund? ›
- Vanguard Real Estate ETF (VNQ) ...
- iShares Core S&P Total U.S. Stock Market ETF (ITOT) ...
- Consumer Staples Select Sector SPDR Fund (XLP) ...
- iShares 0-3 Month Treasury Bond ETF (SGOV) ...
- Vanguard Utilities ETF (VPU) ...
- iShares U.S. Healthcare Providers ETF (IHF) ...
- Schwab U.S. TIPS ETF (SCHP)
Like the Dow Jones and the Nasdaq composite, the S&P 500 is an index of stocks. The S&P is considered by many investors to be the most accurate representation of how the overall stock market is performing, as it uses 500 stocks chosen based on size, industry and other factors to reflect a wide swath of industries.How much should you put in an index fund per month? ›
Lock in a Percentage of Your Income
Most financial planners advise saving between 10% and 15% of your annual income. A savings goal of $500 amount a month amounts to 12% of your income, which is considered an appropriate amount for your income level.
The point isn't to compare active and passive strategies, but rather to make sure you understand that index funds aren't necessarily safe investments. You can lose money if investments in the index lose value. Since many of those indices are financial markets, you should expect them to go down from time to time.What are the risks of index funds? ›
- Lack of Flexibility. An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
- Tracking Error. An index fund may not perfectly track its index. ...
Index Funds Work Well As Short-Term Investments
In general, some advisors suggest that index funds ought to be held for at least five years, if not 10 or more.
- IDFC Nifty 50 Index Fund. ...
- Tata S&P BSE Sensex Index Fund. ...
- ICICI Prudential Nifty Direct Plan-Growth. ...
- HDFC Nifty 50 Plan Direct-Growth. ...
- SBI Nifty Index Direct Plan-Growth. ...
- Aditya Birla Sun Life Nifty 50 Direct-Growth. ...
- Axis Nifty 100 Index Fund Direct-Growth. ...
- Tata Index Nifty Direct.
This burgeoning passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the 'Big Three'.What are the top 3 stock indexes? ›
The three most widely followed indexes in the U.S. are the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite.Why is passive income so powerful? ›
In short, passive income is important because it creates stability, security, and freedom in your financial life. Additionally, since passive income is not limited by your time and effort, it can have a positive, and significant, effect on your ability to build wealth.What percentage of investors are passive? ›
Sure, index funds have ballooned in size, but most estimates put passive ownership of the US stock market at around 15% -- not enough to get worked up about.Are passive funds better than active? ›
The debaters however agreed that for large-cap companies, passive investing is a more ideal choice since it avoids the risk of human bias and gives returns that are in line with how larger markets have performed.Why has passive portfolio management strategies increased in use over time? ›
Why have passive portfolio management strategies increased in use over time? Passive portfolio management strategies have grown in popularity because investors are recognizing that the stock market is fairly efficient and that the costs of an actively managed portfolio are substantial.What is the most stable passive income? ›
1. Real Estate. Despite fluctuations over the recent years, real estate persists as a preferred choice for investors looking to generate long-term returns. Specifically, rental properties can furnish apartment owners with a regular income source.Is Vanguard all passive? ›
Vanguard index funds use a passively managed index-sampling strategy to track a benchmark index. The type of benchmark depends on the asset type for the fund. Vanguard then charges expense ratios for the management of the index fund. Vanguard funds are known for having the lowest expense ratios in the industry.Which Angel is the passive investor? ›
The passive angel is the person who wants to invest money in a few firms but doesn't want to get involved. They only have financial capital to offer.
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 is the aim of passive investment? ›
Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and holding them long term. It can lower risk, because you're investing in a mix of asset classes and industries, not an individual stock.What is a passive index portfolio? ›
Passive portfolio management can be referred to as index fund management. This is because a passive portfolio is typically designed to parallel the returns of a particular market index or benchmark as closely as possible. For example, each stock listed on an index is weighted.What are three techniques for constructing a passive index portfolio? ›
There are three main ways in which a portfolio could be constructed to track an index: Full Replication; Optimization (or sampling), or; Synthetic Replication.