What Is an Index Fund?
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How Do Index Funds Work?
An index fund pools money from different investors. Unlike traditional investment funds that seek to actively manage their holdings and “pick winners,” an index fund attempts to mirror the performance of a particular financial market index, such as Standard & Poor’s 500 (S&P 500), the NASDAQ Composite Index, or the Bloomberg Barclays Aggregate Bond Index.
Note that an index fund still has a fund manager, but it avoids trading stocks to try to boost returns. A typical index fund will own the same holdings in the index and in the same proportions.
Without the active buying and selling of the underlying investments, the operating expenses for an index fund are usually much lower. This makes an index a truly passive investment vehicle, making the average expense ratio of an index fund about 0.2%—five times lower than a mutual fund’s. Keeping operating expenses low is one of the keys to the success of index funds; the higher fees typically charged by actively managed funds create a “headwind” that detracts from their returns.
Like other investment funds, index funds can generate passive income. If the index fund invests in stocks, the fund will pass those dividends back to the fund’s investors on a regular basis. If the index fund owns bonds, it will pass the interest payments back to the fund’s investors.
Influential figures, including Warren Buffet, have recommended index funds (particularly S&P 500 index funds) for building a retirement plan, as they simplify decision-making and portfolio management while providing accessibility to smaller-scale investors.
How Index Funds Compare to Mutual Funds and Exchange-Traded Funds (ETF)
These three terms are often used interchangeably but represent different investment products. The terms “mutual fund” and “ETF” describe the fund’s structure, whereas “index” refers to the fund’s investment strategy.
Mutual funds pool investments into a basket, allowing investors to diversify their portfolio and worry less about making personal trading decisions, thanks to the fund manager that does the decision-making for them. This professional oversees the mutual funds and the buying and selling of the fund’s underlying assets on behalf of all the fund’s investors.
Historically, mutual funds (in particular, actively managed mutual funds) charged higher fees for their services. Investors buy shares of mutual funds from the fund company through a broker, and can redeem (i.e., sell back) the shares to the fund company for cash.
Mutual funds can be actively managed strategies, in which the fund manager attempts to select investments that they believe will outperform the market. Some mutual funds follow an indexing strategy, including some of the biggest mutual funds in the U.S.
Most ETFs fall under the category of index funds. ETFs operate like traditional index funds, but while mutual and index funds can only trade once per day (after the markets close), ETFs allow investors to trade directly from an exchange any time of the day. Unlike in mutual funds, ETF investors typically buy and sell shares from other investors.
In addition, ETFs are also more accessible than mutual funds. Some mutual funds require a minimum investment amount, which may run into thousands (or millions) of dollars. On the other hand, an investor can start investing in an ETF for the price of one share, which can be as low as $50, plus other fees. Some brokers, like Robinhood, even offer fractional shares—or portions of a full share—allowing an investor to start in an ETF for as low as $1.
Index Funds vs. (Rental) Real Estate
Index funds and real estate (particularly rental) are contenders for long-term passive investments. In terms of yield and return, however, there are some notable differences between the two.
Barrier to Entry
Index funds are generally less expensive investments. As a result, it is a path that welcomes first-time investors and those with limited money to invest. In contrast, real estate rentals can be high-commitment, ongoing ventures that require significant capital.
Rentals require regular upkeep, which costs time and money, to generate returns. By contrast, index funds charge negligible (if any) extra costs.
Most brokerages allow investors to take out money from index funds at any time (by selling their shares in the fund). The gains realized from this act are taxed at normal income tax rates for withdrawing money invested in the fund for less than a year or more favorable long-term capital gains tax rates for money invested in the fund for more than a year.
On the other hand, real estate liquidity is highly dependent on the volatile housing market, which determines property values along with how quickly a property is likely to sell on the open market. However, long-term capital gains tax rates also apply to real estate, such as in a buy-and-hold scenario.
Returns on index funds depend on many factors. For example, an investor’s returns will vary based on what index is being tracked, how the global economy is doing, if they are investing in a specific sector index, and how that sector is doing. For international index funds, it is also important to assess how the exchange rate has changed over time.
The most frequently tracked index is the S&P 500, which averaged a return of 8% per year from 1957 to 2018. Note that past returns are not indicative of future returns, and returns in any given year over that period varied wildly, including several years in which this index gained or lost more than 30%.
In comparison, the real estate and rental income markets have been comparatively more stable over that same period. With a long-term tenant, rental income can be stable and profitable.
How to Buy an Index Fund
Compared to real estate, an index fund has a lower barrier to entry, allowing almost anyone to buy an index fund (or start investing in it) regardless of age and employment status. Even children (via a parent or guardian) can invest in an index fund through a custodial account (e.g. UGMA/UTMA account), and will be granted full ownership to their accounts once they turn 18 or 21 depending on relevant state laws.
Generally, buying an index fund involves four steps.
1. Choosing a Market Index
The first and most critical step is to choose which index to track. In the U.S., major indexes include the S&P 500, Dow Jones International Average, and Nasdaq Composite. Some investment companies also support international stocks and bonds.
There are also smaller indexes that investors choose based on several factors, such as geography, company size, or type of assets. For example, real estate-minded investors may invest in real estate ETFs, which primarily focus on real estate investment trusts (REITs).
2. Choose an Index Fund
Investors should next choose the index fund that tracks their chosen index.
3. Setting Up an Account
Investors need an investment account that can hold index funds or ETFs. Frequently this is a standard brokerage account, but tax-advantaged accounts such as IRAs and 401(k)s can generally invest in index funds as well.
4. Buy the Index Fund
Most investment accounts allow investors to simply type the ticker symbol of the fund they want to purchase, decide how much they want to buy, and then buy the index fund. Individuals who invest regularly can also set schedules to buy an index fund regularly.
Some accounts will also ask the investor what they should do regarding dividends, i.e., whether they are to be deposited into the investor’s bank account as cash or reinvested in the index fund.
How to Compare Index Funds
Not all index funds will have the same returns, even if they track the same market index. There are a few reasons this can happen, such as:
- Expense Ratio. Expense ratio is the percentage of the investor’s investment that the fund company charges to operate the investment. For instance, even if Index Fund A and Index Fund B track the same index, but A has a lower expense ratio, investors in Index Fund A can expect a higher payout due to lower fees. The expense ratio is typically paid out of the fund’s assets.
- Other Fees. Apart from the expense ratio, other fees, such as the initial sales commission from purchasing an investment, differ between companies. The cut they deduct will directly affect the return. Some companies offer reinvestments at no extra cost, so investors can put more money over time without worrying about paying additional transaction or administrative fees.
- Tracking Error. An index fund’s manager will try to perfectly replicate the performance of an index, but perfect tracking isn’t possible. As a result, an index fund’s performance won’t be exactly the same as the index.
Index funds are investment funds that follow an indexing strategy: rather than trying to pick and choose investments that will outperform, they’ll invest passively in an index composed of many different companies. Passive investment strategies require much less time and effort to execute, and as a result they can keep their fees low. Index funds are a way to invest that’s much more accessible compared to real estate investing–you can invest in an index fund for the price of one share (or sometimes less).
Index funds are often compared with real estate, particularly rentals, in the area of long-term passive investment. While index funds are more accessible, real estate has historically been more stable.
Reviewed by Chris Wiesehan, CFA and President of CJW Capital
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