An index fund is a type of mutual fund or exchange-traded fund (ETF) that is put together to mirror a specific market index. For example, the S&P 500, which is likely the most famous index, consists of the 500 largest American companies by market cap. An S&P 500 index fund consists of and tracks those 500 companies.
Index funds can be one of the greatest tools in investing when used, and they can be especially helpful for those who may be new on their investing journey. But, as with everything else, there are pros and cons. Here are three reasons to invest in index funds and one reason not to.
1. Low costs
Because index funds follow a set index and criteria -- such as company size, industry, or mission -- they are passively managed and have low management fees (referred to as expense ratios). On the other hand, with actively managed funds, professional investors do the research and choose the companies within a fund, so the management fees are much higher. Even a single percentage point can lead to a difference of thousands of dollars in the long run.
For example, if you invested $20,000 into an index fund that returned 8% annually, in 20 years, you'd have around $93,220. If you invested in a mutual fund with a 1% higher management fee, that same investment would only be worth around $77,390 in 20 years.
2. You get instant diversification
"Don't put all your eggs in one basket" applies to many aspects of life, and investing is no different. One of the keys to long-term success is to make sure you have diversity in your investments; that way, your success isn't dependent on just a few companies. Index funds generally provide instant diversification because you get to simultaneously invest in multiple different companies with one single purchase.
Instant diversification is especially helpful for newer investors. Instead of having to go out and purchase companies individually -- something that can be time-consuming because of the research it may take to make sound decisions -- you can choose a reputable index fund and get instant exposure to all the companies within it. This can help ensure your investments include companies of different sizes, industries, and growth trajectories.
3. Index funds have a tax advantage
When you sell an investment for profit, you must pay taxes on the profit (called capital gains) you make. If you hold the investment for less than one year, the tax percentage will be your normal income tax rate; if you hold it for longer than one year, you'll owe your capital gains rate -- which tends to be lower than your normal income tax rate.
Due to the passive nature of index funds, there is very little trading within the fund, which means you won't be paying as much in taxes as you would with an actively managed fund that makes frequent trades.
Lack of control over companies held
When you invest in an index fund, you can choose what type of companies and sectors you want to invest in, but you don't have any control over the individual companies you invest in; it's already set in stone. If it's a price-weighted index, your money will be distributed based on companies' stock prices. If it's a capitalization-weighted index, your investment will be allocated based on each company's market capitalization. Equal-weight indexes divide the investment equally, regardless of any other factor.
There may be some companies that you especially like and want to own more of, but you can't do this via the index fund. You'd have to invest in the companies individually. On the other end, there may be a company you're against for specific reasons that you'd now have to be an investor in because they're part of a certain index fund. In that case, your only option would be to not invest in any index fund they're in.
The good outweighs the bad
Index funds can be an integral part of any investor's investment strategy. You get to accomplish a lot of investing fundamentals, like diversification and keeping costs low, simultaneously, and thanks to ETFs, the process of buying them is as seamless as investing in individual companies. The pros of index funds far outweigh the cons for many investors, and investors of all experience levels should consider them for their portfolios.