What is an Index Fund?

Quick question:

Would you rather do ten individual tasks, or just one task that automated nine others?

If you’re like most people, you’d prefer the latter. ✅

The same idea applies to much of the investing world, too. In fact, index funds have turned buying individual stocks into busywork in many cases. This isn’t so if you have a very specific strategy in mind. But in most cases, you’d want a well-balanced and diverse portfolio.

You could, of course, achieve this manually. That would be both time-consuming and tedious though. On the other hand, index funds track a multitude of stocks from a multitude of sectors—some very niche and peculiar—making them an excellent overall choice, no matter the industry you are interested in.

And the best part – they make the process very easy.

So much so that even Warren Buffett recommends index funds to everyday investors. Thus, let’s discover exactly what index funds are, how they work, and how they can work for you.

Ready? Let’s jump in!

Understanding Index Funds 💡

Index funds are a variety of mutual funds and ETFs. They can trace their lineage back to the University of Chicago where two students, Edward Renshaw and Paul Feldstein, proposed an unmanaged investment company in 1960. This idea garnered little support but served as the falling of small stones that started an avalanche in the mountains.

Fifteen years later, John Bogle of Vanguard fame started his first index fund—now known as Vanguard 500 Index Fund. At the time, it was seen as a stupid move garnering it the moniker Bogle’s folly—however, since it made $17 million in its first five years opinions swiftly shifted.

An index fund operates on a simple premise—you can’t outperform the market. Thus, index funds select a market index and try to match it. These come in all shapes and sizes. The best known are the S&P 500, The Dow Jones industrial average, NASDAQ, but basically, there is an index for every kind of security and pretty much every branch of every industry.

Index funds represent one of the main vehicles of the $15 trillion that are held in passive investments worldwide. Since they aim to match and emulate the performance of their chosen benchmark index, they need far less management and strategizing than active funds.

This means they offer lower costs and, since the market itself outperforms most active funds, better returns. Attempting to be mirror images of indexes that track multitudes of companies, they also usually offer excellent and instantaneous diversification.

How an Index Fund Works 🏗

Index funds use a technique called indexing. Basically, it means that a fund tries to buy stocks so that it matches an index it is following. In theory, and often in practice, this means that an index fund will perform almost exactly like the tracked index.

These calculations and purchases are usually computer-driven. There are also multiple ways a fund may decide how exactly to match its tracked index—the three main ways being price-weighted, market-cap weighted, and equal-weighted.

Price-weighted indexes track an asset’s market price and adjust the portfolio so that the biggest share goes to the most expensive assets. A market-cap weighted index on the other hand looks at the market capitalization of each asset when deciding how to balance the fund.

An equal-weighted index puts the same importance on both the price and the market cap. While people like the Nobel prize winner Eugene Fama believe that indexing has in many cases made speculating on individual stocks obsolete, it is still very important to know what type of indexing you are looking at.

A price-weighted fund will need a lot more rebalancing than a market-cap-weighted one—which can drive up the costs. On the other hand, a market-cap weighted index can put a disproportionate emphasis on large-cap companies—thus hampering the fund’s ability to accurately emulate the performance of the market.

These three types fall under what could be called traditional indexing. To reiterate, this means that a fund aims to mimic an index by buying a representative portion of each tracked asset based on any of these ways.

Modern Indexing Techniques 🔎

Synthetic indexing is a newer technique that combines futures trading contracts with investments in low-risk bonds. Synthetic indexing often counterweights the increased risk of dealing with futures by making sure that the bonds purchased are high-yielding.

This strategy of mitigation falls under the broad term called enhanced indexing. Enhanced indexing can, depending on the exact strategy, achieve a multitude of tasks—lowering taxes, especially for non-resident investors, reduce risk, reduce cost, or perhaps even greatly increase chances of greater earning by incorporating active management. This last task however can also lead to an increase in overall costs.

The Good and the Bad with Index Funds 👍 👎

Why Index Funds Matter ❗️

There are three great problems every investor faces—we don’t have infinite time, we don’t have infinite money, and we don’t get tomorrow’s newspaper every morning. Index funds go a long way in alleviating these issues.

Among other things, modern portfolio theory states that diversification is necessary. This means that you ideally want to have securities from as many different companies and sectors as possible—don’t put all your eggs in the same basket, right?

This ensures that even if one, or several of your stocks tank, your investments don’t just keel over. The trouble is that it takes a lot of time to do this one security at a time. Since we’ve already established that index funds track numerous companies and purchase their stocks, it isn’t hard to see how they can be really useful.

The second time-related problem is that you simply can’t always react as potentially catastrophic news for your investments is unraveling. Index funds follow the philosophy that the market is always the winner. Ultimately. And really, looking at its history, it is true.

This means that with index funds you can sit back and relax. Nothing but the most severe of crises will be able to take down all the stocks that a fund has invested in. The ever-growing nature of the market makes our inability to peer into the future far less impairing when we diversify properly.

Index funds, usually being passive investment vehicles, tend to have lower operational costs—less human oversight and action equal fewer people and fees that have to be paid. This also helps with taxes on your stocks. The same principle applies—fewer transactions lead to lower taxes.

It is quite clear how index funds help with a lack of a horn of abundance for money that we all suffer from. We really can’t understate how much various seemingly small fees can eat into your savings over the years and decades of investing—even if you are not one of the million investors being overcharged by their fund manager.

Types of Index Funds 🗂

Like we’ve said, index funds come in all shapes and sizes, so let’s have a look at some of the main types.

Broad Market Index Funds ✔️

Broad market index funds attempt to match the performance of an entire investable market. They tend to boast both low costs and low turnover rates—making them very tax efficient. Their drawback is that they tend to saturate themselves with stocks of large-cap companies, reducing your exposure to newer companies with greater growth potential.

Two noteworthy Vanguard broad market index funds are VITSX, which hit $1 trillion in assets in late 2020, and VTSAX. VITSX has an expense ratio of 0.03%, a yield of 1.30%, and a very high minimum investment threshold of $5,000,000. Its 5-year average stands at 10.96%.

The more accessible VTSAX has a buy-in minimum of $10,000, a slightly higher expense ratio of 0.04%, a slightly lower yield of 1.29%, and a 5-year average of 10.95%. True to the purpose of broad market funds, both of these returns align very closely with the overall market performance.

Market Capitalization Index Funds ✔️

Market capitalization index funds counteract the drawback of broad funds—they specialize in different sized companies and help your portfolio get some exposure to newer, smaller companies.

They can be the right choice for you if you have a longer timeframe for investing and a higher risk tolerance. Smaller companies have a far greater potential for growth than well-established giants but are also more susceptible to total failure. 

iShares Morningstar Small-Cap Value ETF (JKL) is one such fund. It tracks the Morningstar small core index and has a 5-year average of 10.60%. It is interesting to note that its 3-year average is far weaker at 6.26%, but its 1-year average in mid-2021 was greater at 34.08%.

Bond Index Funds ✔️

Bond index funds, as the name implies, invest in corporate, government, and municipal bonds. These can be of varying degrees of quality so whether your strategy involves relying on the security of bonds of things that are too big to fail, high-risk high-reward junk bonds, or any other kind of investing in bonds, these index funds have you covered.

A fund focusing on the Bloomberg Barclays 1 – 5 year government/credit bond index is the Fidelity Short-Term Bond Index Fund (FNSOX) launched in 2017. It has a 3-year average of 3.72%, a yield of 1.10%, and an expense ratio of 0.03%.

Dividend-Focused Index Funds ✔️

Dividend-focused index funds focus on stocks that distribute regular dividends. These funds come in two main flavors—growth and yield. Growth indexes focus on companies that are likely to raise their dividends, while yield-focused ones simply track stocks with relatively high dividend yields.

These funds are great if you are looking to turn your investment into regular income. Of course, dividend investing and reinvesting is an age-old and ever-popular strategy and might always be something worth considering. Just be wary as your dividends might be taxable even if immediately reinvested. 

SPDR S&P Dividend ETF (SDY), for example, has a yield of 2.52%, and a 5-year average of 12.62%.

Sector Index Funds ✔️

If you want to keep the benefits diversification brings, while also taking advantage of a rising trend, sector index funds are the choice for you. They track specific sectors, from very broad like utilities or mining, to some very niche options.

One such niche sector fund is the Procure Space ETF (UFO). This fund follows an index of space and satellite-related businesses. It was launched in 2019 so the data for long-term performance isn’t there yet, but its 1-year average is quite impressive standing at 58.96%.

On the flip side, its yield is 0.99% and it has a rather high expense ratio for a passively managed fund—0.75%.

International Index Funds ✔️

If you want to invest in foreign markets, especially the broad ones, most index funds won’t cut it—they tend to focus on the US markets exclusively. International index funds come onto the stage here, just like the cavalry at the climax of a Western.

They help you get exposure to various markets abroad—the London stock exchange, the German market, or the Nordic countries with the help of the FTSE Nordic 30 Index. International funds can also be your only hope in some cases—if you’ve got a taste for Bitcoin ETFs, for example.

It is also noteworthy that an international index fund doesn’t have to focus on a particular country or region. it can, for example, track an aggregate index of various emerging markets the whole world over. One such fund is the Schwab Emerging Markets Equity ETF (SCHE).

This fund has an expense ratio of 0.11%, a yield of 1.99%, and a 5-year average of 11.77%. Some of its top holdings come from China — Tencent, Alibaba— and Taiwan — Taiwan Semiconductor Manufacturing Co Ltd.

Socially Responsible Index Funds ✔️

Socially responsible index funds aim at providing competitive results while avoiding investments in problematic companies. Obviously, what problematic means can vary wildly based on your values.

It could be something obvious like Nestle, or oil companies—but could also include myriad US companies believed to be involved in worker abuses abroad. It could even be companies accused of similar behavior that would find their place in international funds.

Fidelity Sustainability Bond Index Fund (FNDSX) takes a rather interesting approach as it is also a bond index fund. This means that you technically support companies whose politics you agree with by borrowing funds for them.

This fund has an expense ratio of 0.10% and a yield of 1.59%. It was launched in 2018 and has a 1-year average of -0.73% but has had far better months in which it went over 8% returns.

Leveraged Index Funds ✔️

Claiming to double, or triple the performance of their tracked index, these funds might appear very appealing, but they are also really, really capricious. You see, this multiplication of the index’s performance goes both ways—the losses are enlarged, just like the gains.

These funds achieve this through several means the chief of which is borrowing, or leveraging money. This being said, these funds should be viewed as high-risk high-reward and approached as such. They also have potential use in the short term to hedge against big market shifts.

Direxion Daily Financial Bull 3x—which like many leveraged funds indicates its goal with the 3x in its name—is a fairly successful fund. Its expense ratio stands at 0.99% and has a 5-year average of 33.09%. Hoverer, its 1-year average in 2021 is what is truly impressive being 270.58%.

Index Funds and Actively-Managed Funds Compared ⚖️

While both mutual funds and ETFs come in active and passive varieties and follow the same basic idea—that the diversification of your portfolio is inherently good—active funds have seemingly spent another year underperforming compared to their pilotless counterparts.

It is certainly true that certain actively managed funds have stellar performance —ARK Innovation ETF (ARKK), for example, with its 5-year average of 46.93%—these are relatively few and far between though. Additionally, whether active funds bring better returns or not, they do tend to come with significantly higher fees.

On the other hand, while index funds tend to stay around 10% returns unless you pick a particularly bad sector to invest in, their performance depends nearly solely on that of the market. You usually don’t really have to worry that much about a manager changing, or the fund changing strategies in its newest bid to outperform the market.

While it may be condemned as a fallacy, a mere appeal to the masses, the popularity of passive investing speaks volumes in its own right. On the other hand, some, like Michael Burry, the author of The Big Short, have for years been arguing for caution as this popularity of passive investing might be creating a bubble.

How to Pick the Right Fund Type for You 👇

It is important to note that there is no one-size-fits-all answer when it comes to investing in index funds. If you have a lot of time and lower risk tolerance, passive index funds can over the years garner you immense returns. This effect is further compounded if you picked mostly very low-cost funds.

On the other hand, active funds can have even better returns and, when done right, can make you significantly richer over far shorter periods. You do need to accept greater risk, especially if you go for a fund with a more aggressive strategy—returns can be lost as quickly as they can be gained when trying to beat the market.

Index Funds as an Asset Class ⚡️

Since index funds come in so many flavors it is difficult to position them precisely as an asset class. Their performance will mostly be dictated by the specificities of the index they are tracking.

For example, an index fund tracking S&P 500 will usually be rather stable, but will not offer extravagant growth. A fund focusing on startups could prove more volatile with stocks it encompasses rising sharply, falling, or disappearing altogether as a company fails.

That being said, it isn’t an awful idea to base your entire portfolio on index funds. If you start investing early and have decades ahead, you could technically pull off putting all your money in a single or a few broad funds. 

This could net you decent returns by the time you retire assuming that the system doesn’t collapse utterly, nor the society goes through cardinal and all-encompassing changes. To call upon his wisdom once again, Warren Buffett explicitly recommends trusting index funds as he doesn’t believe trading individual stock is viable for most investors.

Still, while these funds do offer instant diversification, relying on just one nevertheless counts as going all-in on a very important bet. Furthermore, people like CNBC’s Jim Cramer still prefer a hybrid strategy leaning on the ideas of Peter Lynch. Essentially, this means that they believe you should try and combine investing in funds with picking out and trading individual securities.

Summing up, index funds are a very versatile asset class whether you want to earn money, or just put it somewhere safe. Since your portfolio allocation will always ultimately be your call, you mustn’t let it be a blind decision. 

You should use the abundant research resources and get acquainted at least with the basics of fundamental stock analysis. Bonus points—and likely bonus money down the road—if you find time to research past market, sector, and company performance and put them through technical analysis.

How Index Funds Performed During COVID-19 😷

Do you remember the scare of a market crash back when the Covid-19 pandemic began?  Thankfully, while the market did initially go into a scary decline, that quickly turned into an unexpected victorious return.

This, in turn, means that most index funds did reasonably well. Now, this may have been somewhat expected from the funds tracking a rather stable index like S&P 500, and especially from funds matching delivery companies and such.

However, what is somewhat surprising is that JETS, an ETF focusing on the airline industry, still managed to bounce back 80% in one year after the crash. Furthermore, even in the rougher months of the covid-19 pandemic, its rally remained steady throughout.

The reason this is so curious is that the airline industry was hit especially hard by the pandemic with flights all around the world coming to a grinding halt.

Any way you look at it, for a true glimpse of how most index funds would perform in a crisis, we’d have to look at the crash of 2008. However, findings from that data are hardly surprising. The market crashed and brought down index funds like the Vanguard 500.

However, as the very basis of index funds claim, the market and the fund recovered and grew beyond their pre-crash values. The lessons of that event are not dissimilar from ones that happened during the Coronavirus Crisis—at their very top stands a firm “don’t panic”.

Conclusion 🎁

While the launch of the very first index fund faced a great deal of criticism, its continued success is impossible to deny. Perhaps the greatest merit of these funds remains their amicability to a passive fire and forget approach—a priceless thing in the ever-accelerating world of the 21st century.

However, we must take one last look at the unexpected performance of JETS. The more you venture, the more you should want to err on the side of caution—and this bit of weirdness might be a sign that the worriers that believe the stock market to be vastly overvalued are heralds of a coming decline.

Get Started with a Broker

Are you convinced that index funds are a good fit for your investing strategy? Make sure you get started with a reliable, trusted, and regulated broker.