Index investing is a passive investment strategy in which you buy shares of an index fund that mirrors the composition and performance of a market index like the S&P 500.
Index investing is considered passive because index funds are formulated to follow the index and thus deliver market returns. There is no portfolio manager to oversee the fund or execute trades as there is with actively managed funds. Index funds can include mutual funds as well as exchange-traded funds (ETFs).
While index funds were once considered somewhat unsophisticated, a growing number of investors have come to embrace passive strategies in the last several years: In 2010, about 19% of total assets under management with U.S. investment firms were in passive funds. By 2023, passive strategies accounted for 48%.
Although index funds are considered passive, that doesn’t mean they are risk free; there are specific concerns for investors to bear in mind when considering index investing.
Key Points
• Index funds are mutual funds that try to replicate the benchmark index for a market segment or sector.
• Because index funds are passively managed and have low turnover, which helps keep costs lower than an actively managed fund.
• Indexes — and the index funds that track them — may be weighted by market cap, price, or fundamentals.
• Passive investing in index funds may help restrain investors’ emotional impulses and improve long-term returns.
• Index investing offers diversification and cost efficiency, but lacks downside protection and flexibility.
What Are Index Funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of a market segment — like large-cap companies — or a sector like technology, by following the benchmark index for that sector.
Index funds typically hold a portfolio of securities — e.g., stocks, bonds, or other assets — that are identical or nearly identical to those in the relevant index. The idea is to try to replicate the chosen benchmark’s performance as closely as possible.
Unlike actively managed funds, which employ a portfolio manager that seeks to outperform the benchmark by actively trading securities within the fund, index funds aim to provide returns based solely on the performance of that particular market or sector.
There is an ongoing debate about the merits of pursuing active vs. passive strategies. In 2023, passive investments tended to outperform their active counterparts, according to industry data analyzed by Morningstar. That said, active strategies outperformed under certain conditions, and for specific markets.
There are index funds for the U.S. bond market, the U.S. stock market, international markets, and countless others represented by various market indexes like the Russell 2000 index of small-cap companies, the Nasdaq 100 index of tech companies, and so on.
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How Do Index Funds Work?
When you buy shares of an index fund — typically a mutual fund or ETF — your money is effectively invested in the many stocks or bonds that make up the particular index. This helps add some diversification to your portfolio, potentially more so than if you were buying individual securities.
In addition, index funds tend to be lower cost than active funds, because passive funds don’t require a live portfolio management team.
Passive investing comes with certain risks, however, chiefly the risk of being tied to the ups and downs of a specific market. Without an active manager at the helm, an index fund can only deliver market returns.
Why Index Funds Typically Cost Less
Because index funds are designed to track the securities in a given market index, an index fund’s portfolio is typically updated only when the constituents in the index itself change. Thus, there is typically low turnover in these funds, which helps keep overall costs low.
By contrast, actively managed funds typically employ a more frequent trading strategy in a quest for outperformance, which can add to the cost of the fund. In addition, active funds have a live portfolio manager and thus tend to charge higher fees.
Understanding the impact of investment fees is important to long-term performance, as many investors know.
How an Index Is Weighted
Some indexes give more weight to companies with a bigger market capitalization; these are market-cap-weighted indexes. This means index funds that track a weighted index, like the S&P 500, likewise allocate a higher percentage to those bigger companies — and those companies influence the performance of the index.
Indexes can also be weighted by price (with higher priced companies making up a higher proportion of the index) or by company fundamentals. While the weighting structure of the index may not matter to individual investors at first, it ultimately influences the holdings of any related index funds or ETFs, and may be something to bear in mind when selecting an index fund.
Well-Known Big Market Indexes
There are thousands of indexes in the U.S. alone, each one designed to reflect how a certain aspect of the market is doing. Some of the biggest indexes include:
• S&P 500 Index — Standard & Poor’s 500 tracks the 500 largest companies in the U.S. by market capitalization.
• Dow Jones Industrial Average (DIJA) — The Dow tracks 30 blue-chip companies; this is a price-weighted index.
• Nasdaq Composite Index — The Nasdaq Composite tracks all of the tech companies listed in the Nasdaq stock exchange (one of the major U.S. exchanges); this is a price-weighted index.
• Wilshire 5000 Index — The Wilshire 5000 is a market-cap-weighted index, and it’s considered a total market index because it tracks all publicly traded companies with headquarters in the United States.
• Bloomberg Barclays Aggregate Bond Index — Nicknamed the “Agg,” this index tracks over $50 trillion in fixed-income securities, and is often considered an indicator of the economy’s health.
Top 10 Equity Index Funds
While the above list reflects some of the larger market indexes, these don’t dictate what the most popular index funds may be. Some index funds are more cost efficient or do a better job of tracking their benchmark than others.
Following are the top 10 low-cost U.S. equity index mutual funds and ETFs in 2024, according to Morningstar, Inc., the industry ratings and research company.
1. DFA US Large Company (DFUSX)
2. Fidelity 500 Index (FXAIX)
3. Fidelity Mid Cap Index (FSMDX)
4. Fidelity Total Market Index (FSKAX)
5. Fidelity ZERO Large Cap Index (FNILX)
6. iShares Core S&P 500 ETF (IVV)
7. iShares Core S&P Total US Stock Market ETF (ITOT)
8. iShares S&P 500 Index (WFSPX)
9. Schwab US Mid-Cap Index (SWMCX)
10. Schwab Total Stock Market Index (SWTSX)
How to Invest in Index Funds: Step by Step
Investing in index funds requires as much due diligence as investing in any single security. Here’s how to start.
Step 1: Determine Your Goals, Time Horizon, and Risk Tolerance
You may want to consider some of the basic tenets of investing as you select your index fund or funds. Will you be adding an index fund to an existing portfolio? Are you starting a taxable account? Is this for retirement?
Knowing your goals, your time frame, and how much risk you feel comfortable with will inform the funds you choose.
Step 2: Choose an Index Fund
The name of a particular index fund may catch your eye, but it’s essential to examine what’s inside an index fund’s portfolio before investing in it. Some index funds track a larger market, such as the S&P 500 or Russell 3000. Others track a more narrow or even niche sector of the market.
Determine what your short- and long-term goals are, and what markets you are interested in. You may want to start with a broad market index fund focused on equities or bonds. Or you may want to target certain sectors like technology, sustainability, or health care.
Step 3: Open a Brokerage Account
Open and fund a brokerage account or online brokerage account, and explore the index fund options available. Be sure to check potential fees and trading costs, as well as account minimums and cost per share. The price per share can vary widely.
Step 4: Buy Shares of an Index Fund
Once you’ve selected the fund(s) you want, execute the trade. Decide whether to create an automatic investment (e.g. every month) to support your goals.
Step 5: Consider Your Index Strategy
While it’s possible to simply add one index fund to your portfolio, it’s also possible to populate your entire portfolio using only index funds. Again, bear in mind the pros and cons of index strategies in light of your current and long-term goals for this investment, as well as your risk tolerance.
Potential Advantages of Index Investing
Index investing has a number of merits to consider. As noted above, index investing tends to be cost efficient, and may offer some portfolio diversification. In addition, investors may benefit from other aspects of passive strategies.
Easier to Manage
It might seem as if active investors could have a better chance at seeing significant returns versus index investors, but this isn’t necessarily the case. Day trading and timing the market can be difficult, and may result in big losses or underperformance. After all, few individual investors have the time to master the ins and outs of financial markets.
Index investing offers a lower-cost, lower-maintenance alternative. Because index funds simply track different benchmarks, individual investors don’t have to concern themselves with the success or failure of an active portfolio manager. Also, index investing doesn’t necessarily require a wealth manager or advisor — you can assemble a portfolio of index funds on your own.
Behavioral Guardrails
Investors who pursue active strategies may succumb to emotional impulses, like timing the market, which can impact their portfolio’s performance. Investing in index funds, which takes a more hands-off approach, may help restrain investor behavior — which may help portfolio returns over time.
According to the 30th annual Quantitative Analysis of Investor Behavior (QAIB) report by DALBAR, the market research firm, equity investors typically underperform the S&P 500 over time.
The QAIB report is based on data from Bloomberg Barclays indices, the Investment Company Institute (ICI), and Standard and Poor’s, as well as proprietary sources. The study examined mutual fund sales, redemptions, and exchanges each month, from Jan. 1, 1985 to December 31, 2023, in order to measure investor behavior, and then compared investor returns to a relevant set of indices.
In 2023, the average equity investor earned 5.50% less than the return of the S&P 500 for that year — a common pattern, as DALBAR research shows.
Potential Disadvantages of Index Investing
The potential upsides of passive strategies have to be weighed against the potential risks.
No Downside Protection
Index funds track the market they’re based on, whether that’s small-cap stocks or corporate bonds. So, if the market drops, so does the index fund that’s trying to replicate that market’s performance. There is no live manager who can try to offset losses; index investors have to ride out any volatility on their own.
No Choice About Investments
Individual investors themselves typically can’t change the securities in any mutual fund or ETF, whether passive or active. But whereas active strategies are based on trading securities within the fund, index funds rarely change up their portfolios — unless the index itself changes constituents (which does happen).
Index Investing: a Long-Term Strategy
Some investors may try to time the market: meaning, they try to buy high and sell low. Investing in index funds tends to work when you hold your money in the fund for a longer period of time; or if you rely on dollar-cost averaging.
Dollar-cost averaging is a method of investing the same amount consistently over time to take advantage of both high and low points in market prices. Generally speaking, this strategy tends to lower the average cost of your investments over time, which may support returns. But dollar-cost averaging can be inflexible, and limit an investor’s ability to respond to certain market conditions.
The Takeaway
Index investing is considered a passive strategy because index funds track a benchmark that reflects a certain part of the market: e.g. large-cap stocks or tech stocks or green bonds. Indexing is considered a low-cost way to gain broad market exposure. But index funds are not without risks, and it’s wise to consider index funds in light of your long-term goals.
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FAQ
What happens when you invest in an index?
You can’t invest in an index, per se, but you can invest in a fund that tracks a specific market index. When you invest in an index fund, you’re investing in not one stock, but in numerous stocks (or other securities, like bonds) that match that benchmark. A large-cap index fund would track big U.S. companies; an emerging market index fund would track emerging markets.
How much do index funds cost?
Index funds tend to have a lower annual expense ratio than actively managed funds, often under 0.05%. That said, investment fees can vary widely, and it’s essential to check a fund’s all-in costs.
Are index funds safe?
Investing in the capital markets always entails risk — no investment is 100% safe. That said, investing in an index fund may involve less risk than owning a single stock, because the range of securities in the fund’s portfolio provide some diversification. That doesn’t mean you can’t lose money. Index funds are only as stable as their underlying index.
Is it smart to put all your money in an index fund?
It’s possible to use an index investing strategy for your entire portfolio. Whether this makes sense for you is determined by your goals and risk tolerance. Index investing offers some potential advantages in terms of cost efficiency and broader market exposure, but comes with the risk of being tied to market returns, with no ability to adjust the portfolio allocation.
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