What is an Index Fund?
An index is a specific type of mutual fund designed to follow the growth of a particular market index. For example, an index fund that follows the S&P 500 will attempt to follow the growth of the S&P 500 index. Typical market indices that index funds follow are:
- Dow Jones Industrial
- S&P 500
- Nasdaq 100
- Russell 3000
- Wilshire 5000
Of these the S&P 500 is the most popular, however any market index can be used as the basis of an index fund. Many companies also offer funds based on indices of foreign markets. Foreign markets, particularly in developing nations, tend to outperform American markets thus increasing potential for gain. However foreign markets also tend to be more volatile so investing in foreign indices can be a much riskier enterprise.
Advantages of Index Fund Investing
There are two primary advantages to investing in index funds rather than investing in more traditional mutual funds. Both are fairly simple reasons.
The first is this: mutual funds, even under the best of managers, rarely outperform the market in the long run. That is to say that a fund that follows a particular market index, most commonly the S&P 500, will on average earn more than the majority of mutual funds. This means more money in your account.
The second reason is that index funds cost less than traditional mutual funds. Traditional mutual funds are actively managed. The fund manager has to make a lot of decisions in where to invest, how much to invest in certain areas, when to buy, when to sell, etc.
Because an index fund is following a specific market index the job of managing is much easier, we call these funds passively managed. (That said a manager’s job is still important in an index fund, and as always when choosing a mutual fund you want to make sure the manager of your index fund is a good one).
To highlight this, let’s look at a basic example. We invest $10,000 in two different funds. One is an actively managed fund with an expense rate of 1.2%. The second is a passively managed index fund with an expense rate of 0.2%. We add $100 to each fund every month. Both funds earn a gross return of 10%.
At the end of 20 years, we have $114,587 in our actively managed fund. In our passively managed fund we have $134,188. This is a difference of almost $20,000. Basically in this scenario we are losing a thousand dollars a year. But as time goes on the losses are even greater.
At the 30 year mark, our actively managed fund has an account balance of $282,866. Our index fund, on the other hand, charging a much smaller 0.2%, has a balance of $360,926. A difference of $78,060! At 40 years there is a difference of $131,110.
If our index fund is also performing better than the actively managed fund to begin with (not uncommon), then the earnings difference between the two is even greater.
Getting Started With Index Fund Investing
When thinking about investing in an index fund, the first thing you need to decide is what sort of index fund you want to invest in. The most popular market that index funds follow is the S&P 500.
The S&P 500 is a stable index and traditionally provides fair returns, on average about 15% per year. It is generally considered a safe fund as well as being profitable, which is the reason for its popularity among indexers.
If you’re looking for a more aggressive investment, overseas index funds are a popular choice. Markets in developing nations often outperform US markets by wide margins, and can be an excellent source of profit. Due to volatility in these developing markets, however, the funds are also a much riskier investment.
Now just because you want to invest in an S&P 500 index fund (or whatever type you choose) doesn’t mean that your choice is done. There are a lot of investment companies out there, and most of them offer their own index funds at their own prices with their own managers.
The most important factor when choosing an investment company is price. The cheaper, the better. As we showed above, higher expense rates can greatly eat into your profits, especially over the long term.
Price isn’t everything, though. Not all index funds are created equal. While most tend to follow the base market index fairly closely, some are poorly managed, some just don’t work for whatever reason. Make sure you’re dealing with a reputable company. Look over their past returns, read the prospectus carefully before making your final decision.
Low Cost Index Fund Solutions
One problem that people face when looking at investment options is one of money. Many mutual funds, including index funds, often require high initial investments, $10,000 or more. Not everyone has easy access to this sort of money to open an account.
There are companies that offer lower-cost solutions to opening an index fund account. Companies such as American Century and T. Rowe Price offer investing options that only require a $50 dollar monthly deposit with no initial investment. These plans require that you make an automatic payment from your bank account each month to add to the fund. If you’re looking to start investing for the future but don’t have a lot of cash on hand, these can make a great low-cost solution.