When you can’t beat the market, mirror it
In short:
An index fund is a mutual fund or exchange-traded fund (ETF) whose objective is to track and mirror the performance of a certain index with the most popular being the S&P 500. Index funds often provide their investors with a low-cost, passive way to gain broad market exposure and diversify their investments. These types of funds are an ever increasingly popular way for individual investors to access stock market investing especially through employer-sponsored retirement accounts.
Both mutual funds and ETFs are pooled investment vehicles which collect money from many different investors to implement an investment strategy that could including buying stocks, bonds, or other assets. The fund manager will then implement the stated strategy, in the case of index funds the strategy of the fund is to track and mirror the performance of a stated index.
Well-known examples of index funds include SPDR S&P 500 ETF Trust (SPY) designed to mirror the performance of the S&P 500 and Invesco QQQ Trust (QQQ) designed to mirror the Nasdaq 100. Both funds have been in operation for over 20+ years and have more than a $100B market cap.
Key Points
- Index funds are mutual funds or ETFs whose aim is to mirror the performance of a stated index.
- Index funds typically have very low costs to invest in since they are passively managed.
- These funds often produce the best results for passive investors although there is no guarantee.
In-depth:
How index funds work
Introduced in the 1970s, index funds were quite a change for the mutual fund industry. Instead of investors putting their money in an actively managed mutual fund whose goal was to beat a stock market index. Investors would simply invest in a mutual fund whose objective is to mirror the index as if they were buying it themselves.
When an investor puts money into an index fund, they are essentially buying a very small portion of each stock within that index. For example, if an investor was to invest $100 into a fund which tracked the S&P 500 that investor would, in a sense, be buying $5.54 worth of Apple stock, $5.40 of Microsoft stock, and so on all the way to $.04 of whirlpool stock.
This is because the S&P 500 index is based on a market-cap-weighted methodology. So the amount of influence a company has in this index is determined by the size of the company. The larger the company the more it makes up the index which is why we see the investor $100 goes more toward Apple (the largest company) and less toward whirlpool (one of the smaller companies).
Why index funds?
Typically, when buying any mutual fund or ETF the goal of the investor is to gain diversification and allow them to take a passive approach to investing. But what’s the big deal about diversification? Well, let’s look at an example to see the actual logic that’s being put into effect.
Say you live in a town where you have the ability to purchase any business you would like. You can either buy an entire business or a small portion of ownership in each business in the town. On top of that, you have two choices. First, you can go find the best business in your town and put all your investment into that business which leaves you with no diversification. Or second, you can buy a small portion of every business, including the best and worst, giving you diversification.
Option 1 leaves you with no diversification; however, your entire investment will feel the full effect if the business continues to be successful. Option 2 gives you diversification-you’ll own a portion of the best business- but you’ll also own a portion of the worst business, which may go broke. What is the better option?
Clearly, option 1 is the better option. This illustration, while appearing very simple, is actually similar to the opportunity the stock market provides investors. The challenge, as you might have guessed, is finding the best business. In the example above, if you couldn’t find the best business, option 2 was the better option giving you the ability to own a portion of the best business without having to explicitly identify it. However, the tradeoff is that you also have to own a portion of the worst business.
Traditionally buying a mutual fund allowed investors to pass off the duty of finding the best companies to invest in onto a professional money manager. However, this is no easy process which requires a large amount of skill, time, effort, and skilled staff for which the mutual fund charges a lot of fees.
With an index fund, the idea is to just buy the companies which compose an index with the idea that the fund will perform similar to the index. The advantage for the investor is that the index fund would charge fewer fees since it’s easier to manage and their investment would have more to compound over time.
Types of indexes
While it may be easy to write index funds off as a quick way to a diversified and boring portfolio that will slowly move along and only track an index such as the S&P 500, making such an assumption would be unsound. There are thousands of indexes for nearly every financial market and market segment that an investor may want to focus their participation on. Here are just some of the most popular indexes:
- Standard & Poor’s 500 is a market-cap-weighted index of the largest 500 companies in the United States. This is the index which is often referred to as “the market”. See here: S&P 500.
- Dow Jones Industrial Average is the second oldest US stock market index which tracks 30 large public companies. This index uses a methodology which factors in a company’s stock price and the need for the Dow Divisor. See here: DJIA.
- Nasdaq Composite is a market-cap-weighted index which tracks over 2,500 companies that trade on the Nasdaq -a US stock exchange which the likes of Microsoft and Facebook trade on. See here: Nasdaq Composite.
- Nasdaq 100 an index of the largest 100 companies which trade on the Nasdaq. Uses a modified market-cap weighting system.
- Russell 2000 index composed of 2,000 smaller mostly US companies which many of the large indexes do not cover. See here: Russell 2000.
Index fund alternatives
Plenty of alternatives are available to investors who still want the ease that comes with fund investing but still want to search for the best companies to invest in. Actively managed mutual funds and ETFs may be the first possible solution.
With actively managed mutual funds and ETFs, the money manager and their team will seek to identify and invest in companies which will outperform many of the indexes. These types of funds can vary greatly in what sector or type of investment they focus on. While it is often said that actively managed funds do not perform better than passive index funds especially after fees are considered. It should be noted that while this is broadly true, there is still a meaningful amount of actively managed funds that do perform consistently better than index funds.
The second possible solution would require more work on the part of the investor. They may employ a strategy of building a base percentage of their portfolio of funds (active or passive) with the remainder of their portfolio composed of individual stocks they select. The advantage here is the investor still gains many benefits from fund investing while still being able to tilt their portfolio to companies they believe will perform better than average.
Index fund advantages
There are many advantages an investor can receive from using index funds. The top two benefits are low cost and diversification.
Cost
Since the job of an index fund is to track an index the job of looking for undervalued companies to invest in is eliminated. This means the fund operator can lower their operating expenses by paying far fewer analysts to help the fund manager look for companies. The fund operator then passes this saving onto its investors through a lower expense ratio, the annual fee investors pay to the fund to manage their money. Lower fees to the investor ultimately allow the investor’s wealth to grow with less of a drag.
Diversification
For many investors, trying to “beat the market” by investing in only a handful of different companies is just too risky and time-consuming. Individual stock picking requires a tremendous amount of knowledge and skill which is hard to pick up if it is not your full-time profession. Even if this is the case there is no guarantee of success. Index funds allow investors to easily pull in ownership of a large number of companies both good and bad, thus reducing the risk that anyone stock sinks their investing boat.
Index funds disadvantages
The largest drawback to index funds comes with the fact that by investing in an index fund an investor is admitting they aren’t trying to beat the market. Rather, the investor is okay with just performing averagely.
While this is probably the best route for many investors. It is no secret that there are companies which are worth owning outright on their own. For example, owning Apple, Microsoft, Amazon, or Facebook would have made a huge net positive impact to an investor’s portfolio even if they invested in a couple lower-performing companies as well. For enterprising investors willing to put in the work and research, this is a major drawback to index funds.
Where to find information on index funds
There are a few places you can look to find index fund information. The first would be to look the fund up directly on the fund’s website. For example, say you wanted to look up Invesco QQQ Trust (QQQ) you could simply navigate to Invesco’s website, look up the ticker “QQQ” then look for the fund’s prospectus. This will provide detailed information on the fund including its, objective, expense ratio, and other relevant information.
The second way to find fund information is to look up the mutual fund on a stock data site such as Yahoo Finance or Google Finance. In this case, you could be interested in SPDR S&P 500 ETF Trust (SPY). Looking up the ticker “SPY” then navigating to “Profile” or “Fund Summary” will get you an overview of the fund and its objective.
Frequently Asked Questions
An index fund is a mutual fund or exchange-traded fund which seeks to mirror the performance of a particular index. For example, SPDR S&P 500 ETF Trust (SPY) seeks to track the performance of the Standard & Poor’s 500 index. Index funds are a popular way to passively invest in the stock market.
For those who know very little about investing or the stock market index funds can be a good way to start. Index funds will allow the beginner to effectively own a small portion of many companies without the need to research all the companies on their own. That said, there is no substitute for studying what you’re investing in and talking with a qualified professional.
Index funds have fees, however, they are typically very low usually under .5% which is a driver of their popularity. Annual fees on an index fund can be found by looking up the expense ratio. Other relevant information to know is the load and minimum investment requirement.
Well-known examples of index funds include SPDR S&P 500 ETF Trust (SPY) designed to mirror the performance of the S&P 500 and Invesco QQQ Trust (QQQ) designed to mirror the Nasdaq 100. Both funds have been in operation for over 20+ years and have more than a $100B market cap.