Index funds have grown in popularity significantly over the past few decades. According to the 2016 Fact Book of the Investment Company Institute, there was $15.7 trillion in mutual funds at the end of 2015, and 52% of that was in stock funds. Among investor dollars in stock funds, 22% were in index funds, up from 9% in 2000 and roughly doubling over the past decade. If you don't know much about index funds, you owe it to yourself to learn more, because they might be just what your portfolio needs. Here are seven things to know about them.
There's a wide range of index funds
If you know any index fund at all, you probably know one that tracks the S&P 500, such as the Vanguard S&P 500 Index Fund (NASDAQMUTFUND:VFIN.X). Vanguard was founded by the father of index funds, John Bogle, and it sports lots of index funds. The Vanguard Total Stock Market Index Fund (NASDAQMUTFUND:VTSAX) gives you not just the S&P 500's big companies, but mid-sized and small U.S. companies, too -- more than 3,000 of them. You can invest in the world's stocks, excluding U.S. stocks, via funds such as the Vanguard FTSE All-World ex-U.S. Index Fund (NASDAQMUTFUND:VFWAX) and U.S. and foreign stocks through the Vanguard Total World Stock Index Fund (NASDAQMUTFUND:VTWSX). Want small-cap companies? Look into the Vanguard Small-Cap Value Index Fund (NASDAQMUTFUND:VSIAX). You can be instantly invested in lots of bonds via index funds such as the Vanguard Intermediate-Term Corporate Bond Index (NASDAQMUTFUND:VICSX).
They exist in regular mutual fund form as well as ETF form
You can also invest in various index funds via exchange-traded funds (ETFs) -- which are like mutual funds that trade like stocks, letting you buy and sell as many shares as you want through your brokerage. Solid portfolio candidates are the SPDR S&P 500 ETF (NYSEMKT:SPY), Vanguard Total Stock Market ETF (NYSEMKT:VTI), and Vanguard Total World Stock ETF (NYSEMKT:VT) Many other investment companies, such as Fidelity Investments and Schwab, also offer their own suites of index funds. Just be sure any fund you consider sports low fees.
They deliver better performances than you think
Investing in index fund isn't settling, so don't feel any regret if you're opting not to put all or some of your money in individual stocks. Even Warren Buffett has recommended them for the average investor. This may surprise you: According to Standard & Poor's, as of the end of June 2016, fully 87% of all domestic stock mutual funds underperformed the S&P 1500 Composite Index over the past 10 years. And 85% of large-cap stock funds underperformed the S&P 500. Over the past five years, 95% of all domestic stock funds and 92% of large-cap stock funds underperformed their respective benchmark index funds.
They can pay dividends to investors
Index funds often pay investors dividends, too -- at least stock-based ones do -- based on the underlying companies in them. S&P 500-based index funds recently yielded about 2.1%, while ones based on the Dow Jones Industrial Average yielded 1.8%. Smaller and younger companies are less likely to pay substantial dividends than larger, more established ones, but even the Vanguard Small-Cap Value Index Fund recently yielded about 2%. That's more than companies such as Disney, Bank of America, and Visa recently yielded.
They're often very inexpensive investments
One reason why index funds tend to outperform their more actively managed counterparts is because they generally sport significantly lower fees. After all, a managed fund needs to charge more to compensate its professional money managers, while index fund managers don't have many decisions to make, as they simply hold whatever is in the tracked index. The Vanguard S&P 500 Index fund, for example, charges an expense ratio (annual fee) of just 0.16%, while the SPDR S&P 500 ETF charges 0.10%. Many managed mutual funds, in contrast, charge 1% or more. Over long periods, such seemingly modest differences can amount to many thousands of dollars.
They're copied more than you know
Interestingly, many actively managed mutual funds are quietly mimicking index funds -- leading them to be referred to as "closet index funds." That can result in decent returns, but these funds are charging steeper fees like those of actively managed funds instead of low fees like most index funds do. It's worth comparing recent holdings of your stock funds with those of their benchmark indexes to see how much overlap there is. If there is a lot, you might as well just invest in the index fund, as it will cost you less. (If a fund's returns closely track an indexes returns, that's another clue.)
It's easy to invest in them -- for retirement or other future goals
One of the best things about index funds is that it's rather easy to invest in them. You can do so directly through a mutual fund company, as most have at least some index funds on offer. You can do so through many major brokerages, which generally offer access to hundreds, if not thousands, of funds. You can buy index-based ETFs through your brokerage account, too. And if you're participating in a workplace-sponsored retirement plan such as a 401(k), there's a good chance that its menu of available mutual funds includes one or more index funds.
The more you learn about index funds, the more you will probably like them, as they offer easy, inexpensive, instant diversification and are a great way to save for retirement and other financial goals