Investing, Investing Basics

Index Funds Explained: A Complete Guide for Investors

by Modern Money

Summary: What is an Index Fund?

Index funds are investment funds that follow a benchmark index fund. An example of a benchmark index fund is the S&P 500. When you invest money into an index fund that tracks the S&P 500, you’re investing in the same holdings of that specific index which means that you’re diversified amongst the companies the that it holds. S&P 500’s heavy diversification includes the 500 largest U.S. companies, making your investment well-diversified.

What is a Benchmark Index?

As noted above, an example of a benchmark index is the S&P 500. More broadly, an index is a measure of the performance of the price of stocks, bonds or other tradeable securities in the broad financial market. When someone references “the SPY”, they are referring to the S&P 500.

Here are some examples of other popular benchmarks for index funds:

  • Nasdaq: The Nasdaq Composite tracks more than 3,000 technology-related companies.
  • The Dow Jones Industrial Average: The “Dow” tracks the 30 largest U.S. companies.
  • Russell 2000 Index: The Russell 2000 Index tracks the 2000 smaller companies (also known as the “small cap” index, as it refers to companies with market caps below $2B).
  • The S&P 500: As referenced, the S&P 500 tracks the performance of the 500 largest U.S. companies (want to invest in a low-cost index fund that tracks the S&P 500? Check out our article on VFV vs. VOO).
  • Russell 3000 Index: The Russel 3000 is a capitalization-weighted stock market index that tracks the entire U.S. stock market.

Index Funds versus Individual Stocks

Historically speaking, stocks may rise and fall (with some never recovering – regardless of their size. Think Enron…), but index funds tend to rise over time.

Comparing S&P 500 charts from two years to 30 years reveals consistent long-term performance despite short-term fluctuations. Investing in S&P 500 is a bet on the U.S. economy, while a single company investment relies on its performance.

With that said, when investing in a broad market index fund your performance will be tied to the market as a whole. Take the Russell 3000 Index as an example. During a massive U.S. recession, index funds decline, but they protect against individual company failures.

When you see success stories like Apple, Facebook, Tesla, etc., it can be tempting to invest in individual securities, but it’s important to reminder yourself that those companies are the outliers, not the norm. Even though you may lose out on significant upside of individual securities with the more diversified approach (assuming you picked the right stock and held it instead of locking in your gains), historically the S&P 500 has posted an average annual return of nearly 10% since 1928. Not too bad!

Do Index Funds Have Fees?

Yes, but the fees are significantly lower than a mutual fund, for example, as they’re not actively managed. Some Vanguard index funds have management expense ratios (MER) as low as 0.06%. Over time, the cost savings of these low cost index funds adds up significantly versus a mutual fund that is slowly eroding your returns over time due to its high fees (sometimes in excess of 3%).

An example of a low cost index fund that tracks the S&P 500 is VFV. It’s MER is only 0.06%. To learn more about VFV (and to compare it to its U.S. counterpart, VOO), click here.

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