So What's an Index Fund, Anyway?
Updated: Oct 5, 2020
If you're in the personal finance space, then you might have noticed how everyone keeps talking about index funds and how they're "the smart way to invest." But what does that mean? What is an index fund, and more importantly, is it right for you?
Here's everything you need to know if you want to invest confidently in index funds.
So what is an Index Fund?
Put simply, an index fund is an investment fund made up of multiple shares of a particular market (such as the Total Stock Market, S&P 500, Bonds, etc...) or sector (such as Tech, Real Estate, Healthcare, etc…).
Index funds can be passively managed (Winenance recommended) or actively managed (which usually means you're paying higher fees for management).
The purpose of a passively managed index fund is not to out perform a particular company or market (i.e. “beat the market”), but to perform just as well as that market or sector performs. Some years will be great, where you might have a 20%+ return (considering the average return of the total stock market is 7% - 10%, that’s an awesome return!). Other years, you might be down -5 to -8% or more.
The general strategy of a passively managed index fund is not to make a windfall overnight, but to buy and hold long term in an effort to increase your portfolio balance (i.e. build wealth) with calculated and minimal risk.
With actively managed index funds, you pay someone (through Expense Ratios) to try to beat the market by hand-picking which stocks to buy and sell in the fund. But as Warren Buffet proved, actively managed funds rarely beat passive index funds over the long term.
Unlike buying a share of an individual company, such as Amazon ($AMZN) or Netflix ($NFLX) buying a share of an index fund allows you to purchase multiple shares of a market or sector, which allows you to more broadly diversify your portfolio and investments. And as we all know, a strong portfolio is a diversified portfolio!
Are there different types of index funds?
The great thing about index funds is that there is practically a fund for every market. You have Total Stock Market funds, which cover almost all publicly traded companies in the US. You have S&P 500 funds, which track the 500 top performing companies in the US. You can also have Total Bond Market index funds, which are made up of U.S. investment-grade bonds, as well as many more “market tracking” funds.
There are also sector funds, such as REIT index funds for Real Estate investing. These can be a great option if you want some Real Estate exposure in your portfolio, but don’t want to have to deal with managing multiple properties or being a landlord. Beyond that, there are a plethora of other sectors to invest in: Technology, Healthcare, Financials, Consumer Staples, Energy, etc...
While many of the fund types I have mentioned are based on US markets, there are also international counterparts to many index funds. You can have Total International Stock Market funds which can track the investment performance of the FTSE Index, which is sort of like the international version of the S&P, and measures the market performance in developed and emerging markets abroad (excluding the United States).
The wonderful thing about index funds is that you don’t have to choose just one market or sector.
You can buy shares in a number of funds to even more broadly diversify your investments.
Or, you could keep it simple with a Total Stock Market Index Fund and maybe a Total Bond Market Index Fund, and still be in a strong position to weather the ups and downs of the stock market.
Why would I want to invest in Index Funds?
When you own shares of an index fund (or even multiple index funds), you own not just one company, but all the companies/entities that make up that index.
If you own a Total Stock Market index fund such as VTSAX (Vanguard Total Stock Market) or FZROX (Fidelity Total Market), you own a small portion of over 3,500 companies!
With broad market index funds, you don’t have to worry about one individual company failing or performing poorly, because there will almost always be another company waiting in the wings to take its place. It is far more likely for a single company to fail than hundreds or thousands of companies.
When you look at the trend of the stock market, particularly the S&P 500, you will see that, over time, the market always eventually goes up.
That’s not to say there are not down times...hello Great Depression, Dot Com bubble, Great Recession, and COVID...but in the end, the world continues to spin, businesses keep making money, and the stock market goes up.
More than likely, if you have grown up, lived, or worked in the United States, you have helped one of those 500 companies in the S&P 500 make a profit. You may even be working for one of them right now.
So why shouldn’t you have a share of that profit??
Do I need a certain amount of money to buy an index fund?
Many mutual funds have a minimum purchase amount, including Vanguard’s coveted VTSAX which has a minimum investment threshold of $3,000. However, they (as well as many other brokerages) offer a lower cost option: ETFs.
With many ETFs, you only need as much as the cost of one (1) share to start investing. For example, if VTI (Vanguard’s Total Stock Market ETF) is trading at $165 per share, you would only need $165 to start investing. There are also other brokerages, such as M1 Finance, Stash, and Robinhood, that allow you to buy a fraction of a share with as little as $1.
We are so lucky to be living in the time that we are (despite current events). If our parents or grandparents wanted to invest back in the day, they would first have to get a stockbroker to talk to them, then hope they were making the right stock picks, mail in a check for hundreds (though usually thousands) of dollars, pay the stockbroker to make the trades, and hope they weren’t getting scammed.
These days, there seems to be a new financial service or investment trader popping up every day, and in a matter of minutes we can buy and sell investments, on our own, and start with as little as $1 and no stockbroker commission fees!
Is an Index Fund the same as a Mutual Fund?
So, frequently, people will use the term “index fund” interchangeably with “mutual fund”, but as I noted previously, index funds can be in the form of ETFs and mutual funds.
The index fund is just a definition of what the overall fund (ETF or mutual fund) will hold: Total Stock Market Index, Bond Index, REIT Index, etc…
Many employer retirement plans, such as 401Ks, 403b’s, and 457b’s, include various mutual fund options, in which many of those funds use underlying indexes to build the funds.
For more on mutual funds, check out our post here.
How do I buy/invest in an Index Fund?
The great news is that all brokerage ﬁrms, investment/financial service companies, roboadvisors, and most 401K/403b/457b/HSA providers offer multiple index fund investment options. Some very popular firms are Vanguard, Fidelity, Charles Schwab, M1 Finance, Robinhood, and Betterment.
In the case of brokerage firms and investment/financial service companies, they may be in the form of either mutual funds or ETFs. For roboadvisors and 401K/403b/457b/HSA providers, they will typically be in the form of mutual funds.
Each brokerage/fund manager will have a slightly (or vastly) different allocation of underlying assets (e.g. company shares) within their funds. When looking for a broad market index fund, you generally want to look for a low-cost (i.e. low expense ratio) fund that tracks the total stock market or S&P 500.
When comparing funds, so some of the things to look for are:
Investment fund asset allocation
Most of the companies you know and love (or maybe hate) will be towards the top: Amazon, Netflix, Google, Facebook, Apple, Microsoft… and make up a higher percentage of the fund allocation than some lesser known (and lower performing) publicly traded companies.
Expense Ratios and Fees associated with the account
We usually recommend a fund with an expense ratio (ER) of 0.5% or less and no trade/commission fees.
Note: Past performance is not indicative of future performance, and there are no guarantees that the fund will perform as it did in previous years (including better or worse). However, reviewing past performance relative to the market can give you some indication of how the fund might perform in similar conditions in the future.
The true benefit of an index fund is in its simplicity.
You don’t have to follow a specific company and read prospectuses (or even really worry about what that means). You don’t have to worry about rebalancing your fund allocation, because the funds do it themselves, passively.
In our opinion, broad market index investing is the only true “passive income”.
Whew! That was a lot, but there you have it. Everything you need to know about the basics of Index Funds. At Winenance, our investing philosophy is based around broad market index funds, particularly for new investors, because they allow for a generally hands-off approach, while also (almost) guaranteeing to perform as well as the stock market does. And as we now all know, the market always goes up...even if it's not consistently.
There are many great fund options available for index funds, each with their own benefits. Once you understand the basics, and know what you want to achieve through investing, you can easily and confidently buy (and eventually sell) shares of index funds to reach your financial goals!
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