What is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund that is not actively managed by a fund manager. It consists of a portfolio of assets that is designed to match the components of a specific broad market index.
The index fund attempts to mimic the performance of its benchmark index and therefore provides mutual fund investors with broad exposure to the overall market.
The structure of the fund’s holdings is simple: The fund aims to match the holdings and performance of its benchmark index. So if the weighted composition of companies in the index changes, the fund manager will change its portfolio to match this change.
In the U.S., the major benchmark indices include the Dow Jones Industrial Average, NASDAQ-100 Index, NASDAQ Composite Index, S&P 500 index, and Russell 3000 index.
In Canada, the major benchmark indices include the S&P/TSX 60, S&P/TSX Composite Index, and S&P/TSX Venture Composite Index.
In the UK, the major benchmark indices include the FTSE 100 Index, FTSE 250 Index, and FTSE 350 Index.
In France, the major benchmark indices include the CAC 40, CAC Next 20, and CAC Mid 60.
In Germany, the major benchmark indices include the DAX.
In Australia, the major benchmark indices include the S&P/ASX 200.
In China and Hong Kong, the major benchmark indices include the Hang Seng Index and Shanghai SE Composite Index.
There are an overwhelming number of smaller indices that track specific sectors, asset classes, investment strategies, and even geographical regions.
In an index fund, rather than an investor actively researching and picking specific stocks or bonds himself, or having a mutual fund manager pick them for the investor, the investor effectively buys all the major stock movers in the market and passively watches his investment grow as the market grows over time. An index fund is cheaper, more passive, and removes the problem of human emotion that can lead to investing mistakes.
As of December 2021, index funds across the globe had over $12 trillion in total assets under management.
The Origin of the Index Fund
The first index fund, First Index Investment Trust, now called Vanguard 500 Index Fund, was set up in 1976 by Vanguard chairman John Bogle. Vanguard 500 Index Fund mirrors the S&P 500 in its holdings and performance.
First Index was launched with $11 million in assets under management. As of April 2022, Vanguard 500 Index Fund had about $800 billion in assets under management.
The original idea was simple: Give the average investor, who has no time or interest in studying stocks, an opportunity to own a diversified portfolio of stocks in the broad market and enjoy passive investment returns that match the returns of the broad market.
Hence the index fund was born and its popularity has grown ever since as global index funds have amassed over $12 trillion is assets under management since 1976.
Benefits of an Index Fund
Index funds are the ideal vehicle for a passive investor who wants the broad market to work for him and grow his money.
Performance
The biggest driver of investor money into index funds has been the performance of index funds over time.
The index fund manager builds a portfolio whose assets mirror the securities of any specific broad market index. The fund will then be expected to match the performance of the index.
Let’s use stocks as an example. Over an extended period of time, the broad stock market grows in value. In fact, the average stock market return is about 10% per year over the last century. This is not necessarily true of stocks of individual companies in the market. However, unless an investor spends a substantial amount of time researching individual companies and analyzing stocks, it is very difficult to predict which stocks will do well over time.
Even stock experts get their market predictions wrong most of the time as they attempt to pick winners and time the market in their portfolios.
To put this in perspective, only 11% of U.S. equity fund managers actively investing in large-cap stocks managed to beat the broader U.S. stock market from 2010 to 2020. In other words, a small fraction of active fund managers can beat the performance of passive index funds.
As such, investing in an index fund that mirrors the broad market is a better idea. In fact, even investing gurus such as Warren Buffett have recommended index funds as a great long-term investment for the average investor.
We used stocks in our example above but there are index funds that track every asset class including bond index funds, commodities index funds, and cryptocurrency index funds.
Lower Management Fees
Because there is no fund manager actively managing the index fund, the management fees of an index fund are generally much lower than the fees of an actively-managed mutual fund in which the fund manager is periodically analyzing, buying, and selling assets in the portfolio.
The passive nature of the fund’s investment structure and operation makes it very cost-effective. The index fund does not need a large research department and there is less trading in and out of investment positions, thus the transaction and management fees are lower.
The fees associated with a mutual fund or index fund are expressed as Management Expense Ratio (MER).
MER is the combined total of the management fee, operating expenses, and taxes charged to a fund during a specific year expressed as a percentage of a fund’s average net assets for that year.
Index fund management fees can range from as low as 0.02% to about 0.3% of the value of the assets under management.
These index fund fees are small relative to the average fees incurred in an actively managed fund, which can range from 0.5% to as high as 2.5% in some mutual funds.
In hedge funds, an investment fund vehicle that is reserved for accredited investors, the management fees are 2% of the value of the assets under management, plus a performance fee of 20% of the fund’s profits.
Lower Transaction Costs
In addition to the lower fund management fees incurred by the investor, the passive approach to the investment strategy means that the investor is not regularly buying and selling the underlying asset.
When an investor buys a stock, a sharp movement in the stock price may trigger feelings of fear or greed, which push the investor to buy or sell the stock. Each buy and sell transaction generates additional trading fees charged to the investor’s portfolio. Over time, these trading fees add up and can take a significant bite out of the returns in the investor’s portfolio.
The lack of regular buy and sell transactions in an index fund reduces the investor’s transaction costs. And most index funds charge no fees when an investor buys units of the fund.
Lower Income Taxes
If emotion causes the investor to constantly buy and sell stocks in the portfolio and the investor doesn’t hold a stock for at least 12 months, instead of lower capital gains taxes, higher income taxes on profits will also kick in to damage the returns in the investor’s portfolio.
Therefore, with an index fund, the investor is less likely to be a trigger-happy buyer and seller, which will reduce his tax bill and boost the returns in the investor’s portfolio.
Diversification
By buying an index fund, an investor is heavily diversified across the major companies and industries in the broader market.
This diversification protects the investor’s returns from a negative performance in any single company or industry.
Index Exchange-Traded Funds
Index funds can be structured as mutual funds, which are trusts that sell trust units to investors.
Or index funds can be structured as exchange-traded funds (ETFs).
In an ETF, a fund management firm brings together assets in its portfolio to match the holdings and performance of a specific index. Then, an investor purchases a share in the firm when he buys the publicly-traded ETF. Thus, the investor owns an ownership stake in the underlying portfolio of the firm.
The investor can trade in and out of his ETF as he would trade in any stock. The investor can make a long or short investment in the ETF as he would trade in any stock.
Types of Index Funds
According to the Index Industry Association, there are nearly 3.3 million stock market indices around the world. Therefore, there are more indices than publicly-listed companies.
If you’re thinking that’s an absurd number of indices, you are right. We’ll focus here on some major indices only.
There is an index fund looking to mirror almost every major index. Indices can track specific sectors, asset classes, investment strategies, and even geographical regions.
Traditional Index Funds
Traditional index funds track the most popular benchmark indices such as:
– S&P 500 – 500 largest companies listed on U.S. stock exchanges.
– Dow Jones Industrial Average – price-weighted measurement stock market index of 30 prominent companies listed on U.S. stock exchanges.
– NASDAQ-100 Index – equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ.
– MSCI EAFE Index – designed to measure the equity market performance of developed markets outside of the U.S. and Canada. EAFE stands for Europe, Australasia and Far East.
– Russell 3000 Index – measures the performance of the 3,000 largest public companies in the U.S.
– Barclays Capital Aggregate Bond Index – measures the performance of high-quality U.S. bonds.
– Bloomberg U.S. Aggregate Bond Index – measures the performance of the entire U.S. bond market.
– Wilshire 5000 Total Market Index – measures the performance of all stocks actively traded in the U.S.
Investors can seek out index funds and ETFs that track these major indices.
Customized Traditional Index Funds
These are index funds that carve out and mirror a section of a broad-based major index.
For example, a Dividend Index Fund can choose to only track the performance of companies in the S&P 500 that pay dividends.
Other index funds may choose to only track the performance of companies in a major index that achieve specific threshold performance ratios related to cash flow, sales and book value.
There are an overwhelming number of ways in which an index fund may choose to carve out and track slices of a major index.
Commodities Index Funds
These funds track the price of a particular commodity such as crude oil, natural gas, gold, or silver instead of tracking a major index.
Some funds buy the physical commodity so an investor in the index fund is a part-owner in the physical commodity. Other index funds simply buy futures contracts related to the commodity. These contracts can be bought and sold for profit in the open market.
Leveraged or Inverse Index Funds
These index funds aim to deliver higher returns than the major index that they track by using high levels of leverage in their investments.
These are higher-risk index funds that are actually actively-managed on a daily basis in order to produce the above-average returns.