With so many investment options to choose from, it can be hard to determine what to add to your portfolio. If you are looking for a quick way to diversify and increase your wealth, including index funds – a type of mutual fund – to your portfolio will help hit your targets.
Index funds are designed to mirror the performance of the stock market or a particular area of the stock market. Because index funds are a type of mutual fund, it pools money from multiple investors, then utilizes the funds to invest in securities including stocks and bonds.
How Do Index Funds Work?
Now that we know that an index fund is a type of mutual fund, the next step in understanding how index funds work is to understand what an index is. Consider an index like a measuring stick of the stock market. Indexes measure the performance of the market, the same way a measuring stick measures how long an item is.
Because there are hundreds of different indexes across many sectors of the stock market, most industry experts use the S&P 500 Index as a benchmark for the overall stock market.
There are different types of index funds that work in similar ways. Some index funds invest in all the securities within a market index while others only include a sample of the securities.
Are Index Funds Good for Beginners?
Many people refer to index funds as “passive” investments. They promise stock ownership across a variety of companies and industries, which immediately diversifies the investors portfolio. This is a great option for beginning investors.
Do Index Funds Have Fees?
One of the most attractive benefits of index funds is they are lower cost than other investments, including mutual funds. They do not rely on analysts to research performance and make stock-selection. Instead, they are simply replicating the performance of the index. This leads to lower transaction fees and commissions.
Do Index Funds Pay Dividends?
Index funds do pay dividends based on the type of security in the fund, whether stocks, bonds, or a combination of both. Index funds can pay dividends monthly, quarterly, or most commonly annually.
Example of a Index Fund
There are many index fund options to choose from. For example, an S&P index fund is comprised of stocks from numerous companies that are found inside the S&P 500. This can include Microsoft Corp. (MSFT), Amazon.com Inc (AMZN), Apple Inc. (AAPL), and Facebook Inc (FB).
The index fund will have a diverse portfolio of companies within the S&P 500 and closely mirror the performance of the index.
Types of Index Funds
Before blindly investing in any random index fund, you should first understand the different types to make sure it is where you want to place your money. While all are passive investments, they have their own sectors, markets, and securities.
Broad Market Index Funds
Broad market index funds try to capture the largest, most diverse, set of stocks and/or bonds in one swoop. This type of index fund has a low expense ratio, and asset turnover is also low. However, it is important to note that if you invest in other index funds, you could have some overlap with your holdings.
Equity Index Funds
An equity index fund is a type of fund that only invests in stocks, not bonds. This type of index fund allows investors to buy ownership in the business, which provides you with returns based on the gains of the companies within the fund.
Bond Index Funds
By contrast, a bond index fund is a type of fund that only invests in bonds, not stocks. This can include corporate bonds and municipal bonds. This type of index fund provides a safety net against stock market volatility, while continuing to have a modest interest return.
Balanced Index Funds
Having a well-diversified portfolio is highly attractive to many investors. A great way to quickly diversify your portfolio is to invest in a balanced index fund which is comprised of both stocks and bonds – all within one investment vehicle.
Sector Index Funds
Throughout the market there are various sectors – from real estate to technology and everything in between. If you prefer to invest in one sector, a sector-based index fund can help you do just that. This type of index fund is ideal for investors who want to gain portfolio coverage to a specific industry trend, without having to “place their bet” on which company will come out on top.
For example, if you believe that the technology sector is going to take off, but you aren’t sure which company will go the furthest you can invest in an index fund within that sector, without the worry of additional research.
Dividend Index Funds
If you are searching for investments that have growth and yield dividends, dividend-focused index funds are a great option. This type of index fund is ideal for investors who are looking to receive regular income from their portfolio.
How To Invest in Index Funds
Investing in index funds is incredibly appealing for investors. After all, they have low fees and are a no-fuss way to quickly invest your capital. However, knowing where to begin, or which index fund to choose can seem overwhelming.
The first step is to pick which index you want to invest in. The S&P 500 is one of the best-known indexes, but there are numerous other options to choose from. After you have picked your index, you can then look for the specific type of fund you want to invest in, which can then help you customize your investment before pulling the trigger.
After you have picked your index and your desired index fund, your next step is to determine where to buy your index fund. You can purchase this investment from a brokerage or a mutual fund company.
Advantages of Index Funds
Investors of all skill levels find index funds beneficial for many reasons as they come with a litany of benefits. Let’s explore the advantages that these types of investments provide to investors.
Simple Diversification
If you are looking for a quick way to diversify your portfolio, index funds create diversification within a ready-made portfolio. This helps minimize your investment risk in the event one security underperforms.
Low Cost
There are lower taxes and trading costs for index funds compared to other investment vehicles. For example, a mutual fund is essentially the same type of investment class. But with an actively managed mutual fund, you will have more fees and are not guaranteed to get more in return.
Transparency
You do not have to guess what is within your index fund. You simply will hold what is within the index, which does not change often. This allows you to gauge the risk before investing to make sure you are comfortable with where you are placing your money.
Dependable Performance
The point of index funds is to mimic the same returns as the index, minus the fund-management fees. Therefore, if an index that the fund follows does well, you can be assured that the index fund will do well.
Disadvantages of Index Funds
As with any investment, you will have some sort of risks associated. Nothing is guaranteed in the stock market, even with index funds. Let’s review some of the disadvantages associated with index funds.
Can’t “Beat The Market”
Index funds were created to match market performance. If you are looking to outperform the market, an index fund is not going to provide you with a higher return you seek.
Lack of Flexibility
Want to select your own stock? With index funds, you will hold the securities that are provided within the fund, so you will not be able to select your desired stock. Fund managers also do not have the ability to sell stocks that underperform.
No Loss Protection
There is always the chance of market plunges. Because Index funds track with their market, if times are bad and the market plunges, you will see the same impact with your index fund.
Index Fund vs Mutual Fund
There are quite a few differences between index funds and mutual funds. First, index funds try to mimic the market-average return. In comparison, mutual funds are designed to try and outperform the market.
Secondly, index funds have low fees associated with them. Active mutual funds tend to have higher fees.
Lastly, index funds have reliable, predictable performances over time because they mirror the stock market. Mutual funds are less predictable.
However, it should be noted that both are investments that can be beneficial. If you have questions, reach out to your financial advisor to help you assess the risk and reward for each investment vehicle.
Index Funds Are a Good Investment
Index funds can be a great investment for new investors and those wishing to expand and diversify their portfolio in one fell swoop. However, because they are not as flexible as other investment vehicles, you should make sure it is the right option for you before placing your money.
If you are unsure of where to begin with index funds, reach out to your financial advisor. The right financial advisor will help you understand what to expect within your desired index fund and guide you to the options that are ideal to add to your portfolio.