An index fund is a type of mutual fund or exchange-traded fund (ETF). It's a bundle of securities that collectively track the performance of a market index such as the S&P 500.
An index fund often contains the same investments in approximately the same proportion as the index the fund tracks. The index itself is usually focused on a specific sector, geography, or stock exchange.
Investing in index funds has long been considered one of the smartest investment moves you can make. Index funds are affordable, enable diversification, and tend to generate attractive returns over time. Historically, index funds outperform other types of funds that are actively managed by top investment firms.
In 2007, Warren Buffett made a $1 million bet that an S&P 500 index fund would beat the returns of an actively managed hedge fund over 10 years -- and he won in a landslide.
Buffett's victory may be reason enough for some investors to start adding index funds to their portfolios. If you need more convincing, read on to understand what index funds are and why they are so popular.
Benefits of index funds
Index funds enable broad diversification, have low costs, and provide attractive returns. Learn more about these key benefits.
1. Broad diversification
The most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing the likelihood of losing most or all your money.
Consider an index fund that tracks the S&P 500. This index fund would hold about 500 different stocks. While the performance of each of these 500 stocks fluctuates over time, investing in a fund that holds all of them matches your portfolio's performance to that of the index itself.
Diversifying your portfolio among so many companies by investing money into just one index fund ensures that the value of your portfolio is not too dependent on the fortunes of any one company.
2. Low costs
Another major benefit of investing in index funds is that the costs, including taxes and management fees, may be lower than those associated with other types of investment funds.
Low management fees
The first cost to consider is the management fee each fund manager annually collects. The amount of the fee, which varies based on the value of your holdings, is determined by the fund's expense ratio. If you hold $1,000 in a mutual fund with a 1% expense ratio, for example, you would pay $10 as the management fee.
Actively managed mutual funds have expense ratios that often range between 1% and 2%. Most of the fee pays for portfolio managers to make buy-and-sell decisions in an attempt to outperform the overall market.
Index funds, by contrast, are passively managed. Since they simply track an index by buying and holding all of the stocks in that index, the holdings of the index fund rarely change. The expense ratio is comparatively low because there's much less work required of the index fund's manager.
Index funds' expense ratios typically range between 0.03% and 0.10%, and some index funds have expense ratios as low as 0%. If you hold $1,000 in index fund with a 0.05% expense ratio, then you would pay just $0.50 as a management fee.
Lower turnover ratio
The turnover ratio measures the percentage of a fund's holdings replaced in a single year. For example, if a fund invests in 100 stocks and 10 are swapped out this year, then the turnover ratio is 10%.
Naturally, index funds have a lower turnover ratio than actively managed funds. Index fund turnover ratios are usually about 1% to 2% per year, compared to 20% or higher for some actively managed mutual funds.
Lower taxes on capital gains
If a fund sells a stock for profit, the difference between the initial purchase price and the final sale price is considered a capital gain. Funds with higher turnover ratios accrue capital gains more frequently, which results in more taxes owed by the fund's investors.
This isn't as much of a concern with index funds, though, thanks to their low turnover ratios. Since fund managers aren't selling stocks all the time, there aren't often capital gains to pass through to shareholders.
3. Attractive returns
As Buffett knew when he made his $1 million bet, even the smartest and most diligent portfolio managers can rarely steer actively managed funds to beat index funds. Only about 16% of actively managed mutual funds outperform the S&P 500 over 10 years when you account for the fees they charge, according to research by Standard & Poor's. Other studies support this number as well.
Individual companies both outperform and underperform the market, but, in general, the overall stock market increases in value over time. As a result, index funds yield generally high returns for low cost, which make them an excellent value for any investor.
So, are index funds a good investment?
For many investors, yes, index funds can be a very solid investment choice.
They offer broad diversification, low costs, and a long track record of competitive returns. That combination makes them especially appealing for people who want steady growth without having to pick individual stocks or constantly manage their portfolio.
That said, index funds aren’t a one-size-fits-all solution. They won’t outperform the market (because they are the market), and they can still lose value during downturns. Investors with shorter time horizons or specific income needs may want to pair index funds with other investments.
But for long-term investors focused on simplicity, consistency, and cost efficiency, investing in index funds is one of the most reliable ways to build wealth over time.
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