What Is an Index Fund?
If you’ve read into investing at all, you’ll likely have stumbled on the term index funds. At the same time, you may be wondering what that means. Here are the details on index funds, the market indexes that make them up and what considerations you should make when investing.
- Index funds are a type of mutual fund portfolio, where your money gets pooled together with other investors in stocks, bonds and more.
- They’re passively managed, which makes them more affordable than actively managed alternatives.
- Index funds follow a particular market index, or a specific way to measure the stock market’s ongoing performance.
- Index funds aim to reflect the state of the market, not beat it. This makes them more predictable than other investment options, but less likely to earn big, short-term gains.
- There are a lot of considerations when it comes to choosing an index fund. Do your due diligence before diving in.
- If you prefer, you can choose index funds based on their market sector. This means industries like technology, healthcare and even socially responsible investing.
The answer to your question: what are index funds?
Index funds are a type of mutual fund (and for your reference, mutual funds are portfolios that pool together the money of other investors in stocks, bonds and more). They reflect a particular market index (we define that below). Investors regularly get dividends paid out, which increases the value of their index fund over time.
The goal of an index fund isn’t to beat the market, but rather reflect the ongoing state of the market. Because they’re passively managed (as opposed to actively managed by an individual fund manager), an index fund can be an affordable, hands-off and beginner-friendly approach to long-term investing.
Many people choose an index fund to help them save for retirement, either on their own or within an employer-backed 401(k) or . Since index funds are an investment, they come with some risk. But investors can adjust the risk based on their personal risk tolerance, and many choose to become more conservative as they near retirement age — or whenever they plan to withdraw their investment.
What are market indexes?
Remember how we said index funds reflect a particular market index? A market index is just a way to measure the performance of the stock market. There are hundreds of different index options available, reflecting various economic sectors and asset classes.
Experts often use the Standard & Poor’s 500 Index (more commonly referred to as the S&P 500) as a benchmark for market indexes. This option creates an index of the 500+ top US companies, which they determine based on level of market capitalization. It’s just an example, and far from the only index out there.
The pros and cons of index funds
Index funds have a lot of benefits. The most renowned are their ability to reap long-term rewards. They’re also inherently diverse (and investing experts tout diversification as a go-to tactic). Because they’re passively managed, the fees are lower than actively managed portfolios. And because they’re designed to mirror — not beat — the market, growth is less volatile and more predictable. All of these features make index funds popular for beginners.
That’s not to say there aren’t downsides. If you’re looking for big gains in a shorter time span, you may want to look elsewhere. While they’re predictable, they’re not so flexible. And depending on who you choose to passively manage your index fund, you may be hit with some unsavory maintenance fees.
What to consider when investing in an index fund
When deciding which index fund to invest in, there are a few things worth considering:
- Figure out your goals for investing. Do you want to keep your money liquid or invest it for the long term? Your answer to this question could help you determine whether or not an index fund is right for you at this time.
- What’s your budget for maintenance fees? An index fund manager with higher fees may or may not fit your budget.
- Do you want a price-weighted index (pricier assets get bigger shares in the index, like the Dow Jones Industrial Average) or a market-cap weighted index (companies with higher market capitalizations get bigger shares in the index, like the S&P 500)? There’s also the option of an equal-weighted index, which provides each asset with the same weight, regardless of price or market cap. All of these options affect how much buying and selling goes on in your portfolio.
- Choose your risk tolerance (low, moderate or aggressive) based on your personal preferences. This can change based on how many years you are from your goal, what you’re willing to throw in and more.
- Not all index funds are the same. There are actually various types (including broad market, socially responsible, equity and more), so consider the one that suits your personality best.
Large index funds by sector
Choosing which index fund to invest in is a personal choice. You don’t have to choose by sector, but it’s a common tactic for industry diversification. For your reference, here are some of the most prominent index funds by sector, just to get you started with browsing:
Commonly traded funds in technology:
- Fidelity Select Technology (FSPTX) – This portfolio is made up of at least 90% technology stocks.
- Guggenheim S&P 500 Equal Weight Technology ETF (RYT) – This is an equal-weighted index of S&P 500 technology companies.
- SPDR S&P Software & Services ETF (SXW) – This is an equal-weighted index of software & services companies, as defined by the Global Industry Classification Standard (GICS).
Commonly traded funds in health:
- Fidelity MSCI Health Care Index ETF (FHLC) – This market-cap-weighted index tracks US healthcare stocks across the board.
- T. Rowe Price Health Sciences Fund (PRHSX) – This health sciences fund may be restricted for preferred investors.
- Vanguard Health Care Fund (VGHXC) – This health-oriented Vanguard fund has a minimum investment of $3,000.
Commonly traded funds in energy:
- Vanguard Energy Index Fund (VENAX) – This fund is low cost and includes energy companies in the realm of oil and natural gas.
- Calvert Global Energy Solutions Fund (CGAEX) – The primary concentration is sustainable energy solutions.
- Guggenheim Solar ETF (TAN) – This index watches solar energy businesses specifically.
Commonly traded funds for socially responsible investing (SRI):
- Parnassus Endeavor Fund (PARWX) – A more modern approach to investing, SRI offers a justice-forward approach to wealth building. PARWX promotes workplace positivity and avoids anything related to fossil fuels.
- Vanguard FTSE Social Index (VFTSX) – This fund avoids companies related to alcohol, tobacco and more while promoting eco-friendly, socially just investments.
- PowerShares Water Resources Portfolio (PHO) – PHO is an index focused on conserving and purifying water.
Commonly traded funds in consumer cyclicals:
- Vanguard Consumer Discretionary Index (VCDAX) – For leisure products and services, it’s one of the most well-known in the sector (they also have a Consumer Staples Index (VCSAX) for those seeking a less-risky route).
- SSgA Active Trust – Communication Services Select Sector SPDR Fund (XLC) – XLC covers telecommunication, media and entertainment in particular.
- Fidelity Select Leisure Portfolio (FDLSX) – Think of companies centered around the leisure industry (including the goods and services that go along with it).
These sectors aren’t the only ones available for investing in industry-specific index funds, but they give you an idea of what to look out for.
Index funds are increasingly popular with investors. Now, about 45% of all investing occurs passively (a rate that’s nearly doubled from a decade ago), with the most common type of passive investing being index funds. As a result, knowing the answer to “what are index funds?” is an important step in becoming an educated investor. These beginner-friendly mutual funds may not be big on quick gains, but they can provide stability in an often volatile arena. As long as you do your due diligence and make every consideration before investing in an index fund, you may just reap the long-term rewards.