Index Funds

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Index Funds Meaning

Index Funds are passive funds that pool investments into selected securities. It is a form of mutual fund that replicates a broader market index like the S&P 500. The investment gets diversified into various stocks from different sectors of the economy.

A market indexMarket IndexA market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by listing the historical and real-time trends in different market segments. read more provides a complete purview of the performance of a market segment and thus serves as a benchmark within the stock market. Consequently, a fund that follows the market index is affected by the ups and downs of the whole market rather than a particular firm.

Key Takeaways

  • An index fund is a financial instrument with a portfolio that copies the listing of a market index which is made up of different securities and bonds belonging to multiple segments and industries.
  • This investment product clones the risk and returns of the underlying index by providing an average return on the index’s securities bundle.
  • Such funds are passively managed investment vehicles.
  • These funds yield superior returns in 7 years or more and perform even better in efficient markets where most sectors showcase tremendous performance.

Index Funds Explained

Index fund holds the bundle of securities which are also listed under a financial market index. Although these investments do not need to invest in all the index assets, the investment manager chooses some of the listed securitiesListed SecuritiesListed security refers to a financial instrument such as stocks, bonds, derivatives, etc., registered with and readily tradable on the stock exchanges like NASDAQ and NYSE.read more.  Since the fund is invested in many stocks and bonds across varied sectors and industries, the investors get exposure to the broad market. For instance, Vanguard Russell 2000 ETF is an index fund that invests in a blend of top small-cap U.S. equities listed under the Russel 2000 index. 

Index Funds

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One of the unique traits of such a fund is that it is a passively managed asset. The fund manager finds a suitable market index and prepares an investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile.read more comprising securities listed in the index. In contrast to actively managed funds, the role of the fund manager is limited. For active funds, the managers must constantly brainstorm and modify the fund portfolio. Actively managed investments require adding and removing securities to surpass the returns of the benchmark index. But fund managersFund ManagersA fund manager refers to an investment professional responsible for fund investment strategy formulation and implementation. They collect and invest the money from various investors and create a good variety of managed funds catering to the diverse preferences exhibited by the investors. read more make mistakes; active management adds risk. Whereas, with passive funds, the investors are sure of generating market-linked returns.

Investors looking out for stable assets that offer regular returns can buy the dividend index funds. Such an investment comprises the selected dividend-paying stocks of the index. Some popular ones include Invesco S&P 500 High Dividend Low Volatility ETF that offers a 4.89% dividend, and iShares Core High Dividend ETF, which yields 4.07% of the dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more.

These funds are very different from regular equities, exchange-traded fundsExchange-traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more (ETFs), and mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more. An Index fund follows the portfolio of its benchmark index, which is a classic combination of securities. With other funds, the individual stocks represent a single company’s profit and loss.  An exchange-traded fund replicates the stock exchange portfolio. In comparison, mutual funds are actively managed assets that contain various handpicked securities. It is important to highlight that index funds have a disciplined approach. They have a diversified portfolio comprising only recognized securities of the market.

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Features

The following characteristics distinguish index funds from other investment products:

Index Funds Features

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  1. Holds All or Selected Securities of an Index: The fund can track its benchmark index precisely by allocating funds to all the listed assets or by choosing a few from the bunch.
  2. Lower Cost: The fund is passively managed with few transactions. This leads to a significant decline in the expense ratiosExpense RatiosThe total expense ratio is the total investment cost to the investor who invests in a mutual fund, equity fund or exchange-traded fund. It included the transactional costs of investment, legal, management, auditor fees and many other miscellaneous operational expenses determining the final return on the investment.read more of index funds. In contrast, mutual funds are constantly churning out varying portfolios.
  3. Automatic Rebalance: This type of investment follows and replicates the index of a country. This includes; top winners. This method automatically cleans up the portfolio by removing the underperformers. That too, without any intervention from the fund managers.
  4. Diversification: There is no security-specific risk associated with these investments since it replicates a broad-market index. It covers various sectors of the economy. Therefore, if one industry or sector faces hardship, it won’t affect the fund’s performance much.
  5. Average Return: The portfolio returnsPortfolio ReturnsThe portfolio return formula calculates the return of the total portfolio consisting of the different individual assets. The formula is computed by calculating the return on investment on individual asset multiplied with respective weight class in the total portfolio and adding all the resultants together. Rp = ∑ni=1 wi riread more for these investments are often the average yield of stocks held by an index. Fidelity ZERO Large Cap Index Fund and Schwab S&P 500 Index Fund are promising products of 2021. Their 2020 total return was 20.05% and 18%, respectively.
  6. Well Suited to Efficient Markets: It is often noted that as markets become more efficient, these funds can generate a higher margin. Market efficiency refers to stock prices incorporating all the information quickly and efficiently.
  7. Passive Management: The investment manager merely seeks to buy and hold securities that would represent the index and would go on to match its performance. Since the role of a fund manager is limited, the risk of errors related to inefficient portfolio selection is minimal.

Index Funds Examples 

Following are prominent examples of this fund.

#1 – Schwab Total Stock Market Index – SWTSX

The SWTSX is a comprehensive fund that matches the performance of the Dow Jones U.S. Total Stock Market Index. It exactly clones the overall U.S. stock market along with its total returns. It is a blend of various U.S. small-cap, mid-cap, and large-cap equities. While the net expense ratio is 0.03%, there is no minimum investment limit for this fund. The return on equity is recorded at 19.04%.

#2 – Invesco S&P 500 Equal Weight ETF – NYSEARCA: RSP

This fund replicates the S&P 500 Equal Weight Index since it contains the securities of 505 companies. 99.41% of securities listed are US-based firms operating in different sectors like I.T., health care, financials, etc. It has no minimum limit for investment. The fund’s management fees and expense ratio is 0.20% each. And the return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more is 19.92%.

#3 – SPDR S&P Dividend ETF

One of the popular dividend index funds is the SPDR S&P Dividend ETF.  This one follows its benchmark index, the S&P High Yield Dividend Aristocrats Index. This underlying index has the various securities of the S&P 1500. It includes stocks of top companies like AT&T, Exxon, Mobil, and Chevron Corporation. This product has a gross expense ratio of 0.35% with a fund distribution yield of 2.59%.  The index dividend yield is at 2.85%.

Advantages

Index funds invest in high-potential sectors and comprise a bunch of different securities. The risk is, therefore, diversified. An index has the property of balancing itself. Poorly performing assets get eliminated, and the money is allotted to the stocks at the top of the list.

In the long run, such funds provide profits for at least seven years of holding. They grow with the development of the overall market. Moreover, in efficient markets, such funds yield higher returns. This is the average of all the securities listed under the respective index. Due to the low expense ratio, the investors save on portfolio managementPortfolio ManagementPortfolio management involves overseeing a set of investments, including securities, bonds, exchange-traded funds, mutual funds, cryptocurrencies, etc., on a personal or professional levelread more fees. Costs are cut as these funds don’t require active professional management. They go with the trend of the underlying index.

These assets are easy to manage. They require minimal effort from the fund managers. In comparison, strategizing and handling active funds is hard work. This also reduces the burden on passive fund managers. They are not under constant pressure to generate more indexes.

Disadvantages 

Index funds are prone to the risk of market corrections. Since the fund portfolio is directly related to the market movement or economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more, it observes a steep downfall during economic recessionEconomic RecessionEconomic recession is defined as the phase in which economic activities of a country become stagnant, leading to a disturbance in the business cycle and affecting the overall demand-supply balance. read more or depression. Moreover, as these assets are not managed actively by the professionals, its profitability is limited to the underlying index’s progress. As a result, this fund often bears the tracking errorTracking ErrorTracking Error Formula is used in order to measure the divergence arising between the price behavior of portfolio and price behavior of the respective benchmark and according to the formula Tracking Error calculation is done by calculating the standard deviation of the difference in return of the portfolio and the benchmark over the period of time.read more. A tracking error is a mismatch between fund returns and the underlying index’s returns.

These financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more often come with the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more of not investing in active funds. Also, the investors fail to gain additional returns from growth stocks. Such investment products are not extensively promoted because the brokers and agents get low margins or commissions on selling these funds. These portfolios are rigid and don’t incorporate any changes proposed by the fund managers, making it an inflexible product.

Frequently Asked Questions (FAQs)

What is an index fund?

An index fund is an investment product that reflects and traces the performance of a financial market index by cloning its basket of securities. Sometimes, only a selection of the index securities is chosen by the fund manager.

How do index funds work?

An index fund follows the footprints of a benchmark index. The policies of index funds restrict the fund managers from modifying or restructuring the investment portfolios. These funds are passively managed products. The risks and returns are identical to the underlying market index.

Can you lose money in an index fund?

An index fund is highly diversified. It covers multiple securities such as equities and bonds from companies operating in different sectors, industries, and markets. Although the investors cannot lose all their money in such funds, it is still prone to market risk. The fund is subject to market fluctuations and downfalls.

Recommended Articles

This has been a guide to Index Funds and their Meaning. Here we explain Index fund’s features, examples, advantages, and disadvantages. You can learn more about Mutual Funds from the following articles –

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