Index Funds: What They Are and Why You Should Consider Investing

Wood blocks with letters spelling the word "funds"

If you’re ready to dip your toe into the wonderful and complex world of stock investing, index funds are the perfect place to begin.

What Are Index Funds?

An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to track a specific combination, or index, of stocks, bonds, and other investments.

Many index funds mimic existing market indexes like the Dow Jones Industrial Average (DJIA) or the S&P 500. Every index fund performs the same way as the market index it tracks.

The Dow Jones Industrial Average is an index consisting of 30 large U.S stocks. If you invested in an index fund that mimics the DJIA, it would contain all 30 stocks in similar proportions. For example, the three largest stocks in the DJIA, as of August 2019, are 3M Company, IBM, and Goldman Sachs. These companies account for 6.58%, 5.92%, and 5.7% of the Dow Jones Industrial Average index. And they make up the same percentages of the SPDR Dow Jones Industrial Average ETF, one of the best-known index funds pegged to the DJIA.

There are a few different types of stock index funds. The type described above is known as a broad market index fund because it tracks the performance of an entire market or market subset.

Global index funds are even broader because they provide exposure to stocks across the world. Sector-specific index funds, meanwhile, track the performance of a specific sector like banking, real estate, or insurance.

Index Funds vs. Actively Managed Funds

Index funds and actively managed funds are both forms of mutual funds (or ETFs), but one requires more oversight than the other. It’s important to consider both of these options as an investor.

The manager of an index fund simply aims to duplicate the returns of an existing marketing index by purchasing the same holdings at the same percentages. There’s very little analysis required since the goal is to mimic something that already exists. Since they don’t require much active management, index funds are passive, or passively managed funds.

Actively managed funds, on the other hand, have managers pick and choose investments with the goal of outperforming the stock market. This requires active oversight, in-depth analysis, and significant knowledge of the market.

Index Fund Pros and Cons

While the concept of investing in an actively managed fund that outperforms the market is tempting, it’s not guaranteed. There’s very little proof that actively managed accounts can consistently deliver better results than standard index funds. In fact, index funds have consistently beaten actively managed funds for periods of 10 years or more. Even if you’re able to find an actively managed account with strong performance, you have no way of knowing whether the active manager is brilliant or just lucky.

Index funds offer a few other significant benefits over actively-managed funds:

  • Lower ongoing management expense
  • Lower taxable capital gains due to infrequent buying and selling of stocks
  • Use long-term potential of the stock market without guesswork

And the index fund downside? Mainly, it’s the fact that if you live by the index, you die by the index. If the DJIA or the S&P 500 or whatever benchmark the fund is following tanks, so will the fund. There’s no way to cushion the blow. In contrast, with an actively managed fund, a smart manager can take defensive steps to protect the portfolio—sell losers, or get out of the market altogether for a while.

In the end, there’s no single correct way to invest your money. Some people prefer to invest in actively managed funds to have the opportunity to outperform the market and collect higher returns. Others aren’t interested in taking risks and happily invest in passively managed index funds for long-term results.

If you’re a long-term investor, put time on your side with an index fund. If you’re a short-term investor looking for rapid results, give an actively managed fund a try.

Read about micro-investing and how to get started with our complete guide: Micro-Investing: What It Is, Why It’s for You and How to Start.