Investing can be intimidating, especially now that there are dozens of options available to you as an investor. Index funds, active funds, ETFs, individual stocks, bonds, bond funds, crypto, etc etc...

If you’ve dabbled in the world of investments, you’ve probably already heard about index funds. They have gotten a lot of attention in the recent past.

While index funds are typically considered an ideal avenue for IRA / 401(k) portfolios, even investing guru Warren Buffet has stated that index funds are the best way for ordinary investors to grow their wealth.

But what are index funds? Is it really a good idea to invest in one? Let us jump deep into the realms of the index funds world and learn some crucial aspects of the investment opportunity.
 

What are Index Funds?

An index fund is a kind of exchange-traded fund (ETF) or mutual fund that comes with a portfolio built to match or track a financial market index. A common example would be an index that tracks the entire US market, or the entire global market. Other indexes are more specific such as tracking a certain region of the world, a certain industry (sector indexes), or companies of certain sizes (large cap, small cap, etc).

Index funds are completely hands-off for the investor. They give you access to a diversified portfolio with zero work on your part. They offer broad market exposure, low portfolio turnover (which can be tax friendly) and they generally have low operating expenses.

With an index fund the goal is not to beat the market, but simply match it. The fund manager buys every entity listed in the index in the exact proportion in order to mimic the performance of the index as a whole. So an S&P 500 index fund would own all the stocks on the S&P 500 following the same weighting as the index. If the S&P 500 goes up 1%, then so does the fund. Tracking accuracy is the metric that tells of how close a fund’s actual returns match the theoretical return of the index. Most funds have very high tracking accuracy.

The secret to index funds is they simply try to match the market, as opposed to actively managed funds where the manager is trying to beat the market through clever strategies. Active managers end up losing more often than winning (due to randomness and fees) so why not factor that out of the equation?
 

Why Should You Invest in Index Funds?

Let us discuss a few positive aspects of indexing.

1. Reduced Taxes on Capital Gains and a Lower Turnover Ratio

A capital gain is the difference between the purchase price and the sale price of an investment. In other words capital gains are the profits made when selling. 

As a fund owner, you are allocated a portion of the fund’s capital gains based on the trades it makes throughout the year. That trading is called turnover.

Specifically the turnover ratio is the percentage of a fund’s holdings that are replaced within a year. For example, if a fund invests in 50 stocks and five are swapped out within a given year, the turnover ratio is 10%.

Actively managed funds typically have a turnover ratio of 20% or higher. This ratio is generally somewhere between 1% to 2% for index funds. So with index funds you pay less in taxes.
 

2. Diversification

When you invest in an index fund, your portfolio becomes largely diversified, thereby reducing the risk of losing all of your money at once.

The performance of individual stocks in the index may fluctuate from time to time, but your portfolio is a mirror of the complete index. So if a single stock craters it will only have a small impact on your portfolio’s value.
 

3. Less Excitement but Steady Returns

When you invest in individual stocks, their value fluctuates wildly. You never know if a given stock will underperform or outperform the market. 

With index funds the bet isn’t on an individual stock, but on whatever that index follows (such as the US stock market, the global stock market, the US bond market, etc). Check out our Portfolio Allocation Calculator to get an idea of past returns for US stock and US bonds. Historical returns has averaged out to 9.8% (stocks) and 4.9% (bonds) since 1928. Those numbers may not look huge, but over a 30 year period of building a nest egg the compounding is substantial.
 

4. Reduced Management Fees

Funds make money by charging investors who own the fund. The amount is calculated by multiplying the fund’s expense ratio times the investor’s balance. 

So if you own $10,000 in a fund with an expense ratio of 0.5%, you would pay $50 in fees. This would either be taken out of your account directly, or the fund would sell off assets to dilute your holdings.

Fund expense ratios start and zero and go up to north of 2%. Generally speaking, actively managed mutual funds have higher expense ratios than index funds. The fee primarily goes towards paying the portfolio managers who decide to buy or sell, but it can also go into marketing and other activities that have little to do with managing your money.

Index funds are ‘passive’ in the sense that their only goal is to mirror an index by trading in the stocks of that index. As such their holdings do not change very often. Therefore the manager does not have to work as much, so the expense ratio is lower.

For more about expense ratios and why it is so important to try to minimize them, see our two part series: What is an Expense Ratio Part 1, and Part 2.
 

What Are the Risks of Investing in Index Funds?

Like every investment opportunity, index funds are also not 100% safe. Here are a few risks you should be aware of before you put your money on index funds.

1. Zero Control Over Holdings

When you invest in an index fund, you are investing in a set portfolio. You do not get any control over the individual stock holdings within the portfolio.

If there are any specific companies that you like and want to own a share of, you cannot alter your index fund. Instead, you will have to individually buy that stock and hold it as a separate investment from your index funds. Similarly if there are stocks you want to avoid, you can’t opt out of them if they are included in the index.
 

2. Success Is Not Guaranteed

Simply investing in an index fund does not guarantee you will achieve your financial goals. You cannot rely solely on index funds for returns. If you want to benefit from investing, you will have to use different strategies instead of a blanket mutual fund investment.

Plenty of financial advisors curate portfolios that are suited to their client’s risk appetite and financial goals. If you want to do things yourself, let index funds be the core of your portfolio, but explore other options to enhance the returns.
 

3. Too Many Index Funds Could Be Bad

The explosion of popularity of index funds has concentrated ownership of certain stocks by big brokerage houses. According to Bloomberg:

BlackRock, Vanguard, and State Street combined own 18% of Apple Inc.’s shares, up from 7% at the end of 2009. Of the four largest U.S. banks, the fund companies together own 20% of Citigroup, 18% of Bank of America, 19% of JPMorgan Chase, and 19% of Wells Fargo.

Jack Bogle the founder of Vanguard and index fund pioneer has warned the result is “too many shares in too few hands”.

Not that these brokerage houses are going to do anything with the shares, other than hold them for you. But if a company wants to put something up for a vote to its shareholders, it becomes problematic if most individual investors ignore the vote (since they own the shares indirectly through the fund). There is also the idea that consolidation of ownership stifles competition. Since these huge funds own the entire index, including competitors that work against each other, they want to keep the status quo vs favor one side.

 

Wrapping Up

Investing in index funds can be an excellent way of getting stable returns. However, you should not dive in without understanding everything you stand to lose or gain. Expense ratios are very important to consider when comparing funds that invest in similar indexes.

If you’re interested in long term investing with broad diversification index funds are worth considering.