10 Types of Index Funds Every Investor Should Know About
An index fund to fit all tastes
Index funds have gotten a lot more complex and varied since Jack Bogle created the first index fund back in 1976. They still offer the best way for a typical investor to achieve broad diversification across an asset class without having to spend very much on buying individual securities or paying the high fees associated with actively managed mutual funds. But investors can now use index funds to gain additional exposure to certain markets, sectors, or even investment styles.
Here are 10 types of index funds every investor should know about.
1. Broad market
A broad market index tries to capture a large swath of an investable market. That can apply to stocks, bonds, or any other type of security.
Broad market index funds typically have some of the lowest expense ratios. Additionally, asset turnover is extremely low in broad index funds, and they’re extremely tax efficient as a result.
If you’re looking to get the most diverse basket of stocks or bonds in one go a broad market index fund is for you. Be aware, however, that if you plan to invest in other index funds, you’ll face some overlap with your holdings in your broad market index fund.
Some examples of broad market index funds and the indexes they track include:
- Vanguard Total Stock Market Index Fund (NASDAQMUTFUND: VTSMX) (NASDAQMUTFUND: VTSAX) (NYSEMKT: VTI) tracks the CRSP U.S. Total Market Index.
- Schwab Total Stock Market Index Fund (NASDAQMUTFUND: SWTSX) (NYSEMKT: SCHB) tracks the Dow Jones U.S. Total Stock Market Index.
- Vanguard Total Bond Market Index Fund (NASDAQMUTFUND: VBMFX) (NASDAQMUTFUND: VBTLX) (NYSEMKT: BND) tracks the Barclays Aggregate Bond Index.
If you want to add some outside exposure, international index funds can provide it for you. Many broad market index funds focus specifically on U.S. markets, but there are a whole lot of companies in the rest of North America, South America, Europe, Asia, Oceania, and Africa. (Sorry, the securities markets in Antarctica are frozen.)
International index funds aren’t necessarily grouped by geographic bounds like Western Europe or the Middle East. You could also buy funds that track indexes in emerging markets or frontier markets, which aren’t tied to a specific geographic region.
Some examples of international index funds and the indexes they track include:
- Vanguard FTSE All-World ex-US Index Fund (NASDAQMUTFUND: VFWAX) (NYSEMKT: VEU) tracks the FTSE All-World ex U.S. Index.
- Schwab Emerging Markets Equity ETF (NYSEMKT: SCHE) tracks the FTSE Emerging Index.
- iShares Core MSCI Pacific ETF (NYSEMKT: IPAC) tracks the MSCI Pacific Investable Market Index.
3. Market capitalization
Most broad market index funds are weighted by market capitalization, which could leave you with little exposure to small- and mid-cap companies. Smaller companies historically outperform larger companies over the long run, albeit with greater volatility. That’s because it’s a lot easier to grow earnings or sales off a small base than it is off billions and billions of dollars. That said, the risk of a smaller, less well-established company failing is greater.
Investors with a longer time horizon could benefit from greater exposure to a broad basket of small and mid-sized companies. Index funds based on market capitalization can do just that.
Some examples of market-cap based index funds and the indexes they track include:
- Vanguard 500 Index Fund (NASDAQMUTFUND: VFIAX) (NYSEMKT: VOO) tracks the S&P 500 Index -- the 500 largest U.S. companies by market cap.
- Fidelity Mid Cap Index Fund (NASDAQMUTFUND: FSMDX) tracks the Russell Midcap Index.
- iShares Morningstar Small-Cap ETF (NYSEMKT: JKJ) tracks the Morningstar Small Core Index.
4. Term-based bonds
For fixed-income investors bond terms can play an important part of their asset allocation. Managing a good mix of short-, intermediate-, and long-term bond maturities can provide stable bond income for years to come. Using bond index funds makes the task simple.
Long-term bonds can provide relatively strong returns while interest rates fall and short-term bonds can provide more stable returns. Intermediate-term bonds fall in the middle.
Some examples of term-based bond funds and the indexes they track include:
- Vanguard Long-Term Bond Index Fund (NASDAQMUTFUND: VBLAX) (NYSEMKT: BLV) tracks the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index.
- iShares Intermediate Government/Credit Bond ETF (NYSEMKT: GVI) tracks the Bloomberg Barclays U.S. Intermediate Government/Credit Bond Index.
- Fidelity Short-Term Bond Index Fund (NASDAQMUTFUND: FNSOX) tracks the Bloomberg Barclays 1-5 Year Government/Credit Bond Index.
5. Municipal bonds
Investors seeking tax-free income from bonds will find municipal bonds attractive. But buying individual issues is time consuming and risky. A municipal bond index fund will keep risk and taxes at bay.
Municipal bonds are exempt from federal income tax and they’re often exempt from state and local tax when an investor resides in the same state where the bond is issued. Investors living in states with no income tax can invest in national municipal bonds, but investors living in states with high local income taxes might look for funds that track indexes with muni bonds from their own state.
Some examples of municipal bond funds and the indexes they track include:
- iShares National Muni Bond ETF (NYSEMKT: MUB) tracks the S&P National AMT-Free Municipal Bond Index.
- Invesco California AMT-Free Municipal Bond ETF (NYSEMKT: PWZ) tracks the ICE BofAML California Long-Term Core Plus Municipal Securities Index.
- iShares New York AMT-Free Muni Bond ETF (NYSEMKT: NYF) tracks the S&P New York AMT-Free Municipal Bond Index.
There are two kinds of indexes composed of companies based on their earnings: growth indexes and value indexes. Growth indexes are comprised of companies that are expected to grow earnings faster than the overall market. Value indexes are comprised of stocks that are trading at a low price relative to the company’s earnings.
Growth stocks tend to be more volatile than value stocks, appreciating more in bull markets but falling further in bear markets. Value stocks tend to lag the overall market as prices go up, but don’t fall nearly as far when the market declines -- their prices are already so cheap as is.
Some examples of earnings-based index funds and the indexes they track include:
- Vanguard Growth Index Fund (NASDAQMUTFUND: VIGAX) (NYSEMKT: VUG) tracks the CRSP U.S. Large Cap Growth Index.
- Schwab U.S. Large-Cap Value Index Mutual Fund (NASDAQMUTFUND: SWLVX) and Schwab U.S. Large-Cap Value ETF (NYSEMKT: SCHV) track the Russell 1000 Value Index and Dow Jones U.S. Large-Cap Value Total Stock Market Index, respectively.
Index investors looking for dividends from their portolio can buy dividend-focused index funds. There are two main types of dividend indexes -- growth and yield. While there’s some overlap between the two, dividend growth indexes include companies that consistently raise their dividends and have the potential to keep doing so in the future. Dividend yield indexes merely include stocks with relatively high dividend yields.
Dividend index funds can be great for investors looking for regular income from their investments. That said, reinvesting dividends in dividend growth companies is a popular strategy amongst investors both young and old.
Some examples of dividend-focused index funds and the indexes they track include:
- Vanguard High Dividend Yield Index Fund (NASDAQMUTFUND: VHYAX) (NYSEMKT: VYM) tracks the FTSE High Dividend Yield Index.
- SPDR S&P Dividend ETF (NYSEMKT: SDY) tracks the S&P High Yield Dividend Aristocrats Index.
If you want to invest in a specific sector of the market -- e.g. utilities or real estate -- sector index funds are exactly what you’re looking for. Sector funds are the broadest category of funds since it’s possible to make an index based on any industry. Sectors themselves can be broad -- technology -- or specific -- cloud computing.
Investors that want to gain exposure to an industry trend, but don’t know exactly which horse to bet on will do best by investing in a sector fund and letting the market figure out which company is the winner.
Some examples of sector funds and the indexes they track include:
- iShares U.S. Financials ETF (NYSEMKT: IYF) tracks the Dow Jones U.S. Financials Index.
- Vanguard Consumer Discretionary Index Fund (NASDAQMUTFUND: VCDAX) (NYSEMKT: VCR) tracks the MSCI U.S. Investable Market Consumer Discretionary 25/50 Index.
- Utilities Select Sector SPDR Fund (NYSEMKT: XLU) tracks the Utilities Select Sector Index.
- First Trust Cloud Computing ETF (NASDAQ: SKYY) tracks the ISE Cloud Computing Index.
If you have a conscientious objection to investing in adult entertainment, alcohol and tobacco products, conventional and controversial weapons (including civilian firearms), fossil fuels, gambling activities, and nuclear power, but still want the broad diversification of a broad market index fund, a socially-responsible index fund is what you need.
There’s growing evidence that investing in companies with a focus on companies with high environment, social, and governance standards may offer investors long-term performance advantages. At the very least, you’ll feel good about the companies you own shares in.
Some examples of socially-responsible index funds and the indexes they track include:
- Vanguard ESG U.S. Stock ETF (NYSEMKT: ESGV) tracks the FTSE U.S. All Cap Choice Index.
- Vanguard ESG International Stock ETF (NYSEMKT: VSGX) tracks the FTSE Global All Cap ex U.S. Choice Index.
- Fidelity Sustainability Bond Index Fund (NASDAQMUTFUND: FNDSX) tracks the Bloomberg Barclays MSCI U.S. Aggregate ESG Choice Bond Index.
10. Leveraged index funds
Leveraged index funds seek to return a multiple of the index they’re tracking on a daily basis. They use financial instruments including debt and options to achieve their goals. While getting two times or three times the returns of a broad stock market index like the S&P 500 might sound enticing, the reality is far different.
These index funds reset daily, and as a result they participate in a downturn much more than an upturn. For example, if the S&P 500 index increases 10%, a triple-leveraged S&P 500 index fund will increase 30%. But if the S&P 500 falls 9%, back to even, the triple-leveraged index will fall 27%. That fall will take it from 1.3 times a person’s original investment down to 0.95 times. Leveraged index funds are best used as a short-term hedge against big market moves, not for long-term buy-and-hold investors.
Some examples of leveraged index funds and the indexes they track include:
- ProShares UltraPro QQQ (NASDAQ: TQQQ) provides three times leveraged exposure to the NASDAQ 100 Index.
- ProShares Ultra S&P500 (NYSEMKT: SSO) provides two times leveraged exposure to the S&P 500 Index.
- Direxion Daily Financial Bull 3x (NYSEMKT: FAS)
provides three times leveraged exposure to the Russell 100 Financial Services Index.
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