Index investing is a passive investment techniquethat attemptsto generate returns similar to a broadmarket index. Investors use this buy-and-hold strategyto replicate the performance of a specific index—generally an equity or fixed-income index—by purchasing the component securities of the index, or investing in an index mutual fund or exchange traded fund (ETF)that itself closely tracksthe underlying index.
There are several advantages ofindex investing. For one, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands-off approach to investingeliminates many of the biases and uncertainties that arise ina stock-picking strategy.
Index investing, as well as other passive strategies, may be contrasted with active investment.
Key Takeaways
- Index investing is a passive investment strategy that seeks to replicate the returns of a benchmark index.
- Indexing offers greater diversification, as well as lower expenses and fees, than actively managed strategies.
- Indexing seeks to match the risk and return of the overall market, on the theory that over the long-term the market will outperform any stock picker.
- Complete index investing involves purchasing all of an index's components at their given portfolio weights, while less-intensive strategies involve only owning the largest index weights or a sampling of important components.
How Index Investing Works
Index investing is an effective strategy to manage riskand gain consistent returns. Proponents of the strategyeschew active investing because modern financial theory claimsit's impossible to "beat the market" once trading costs and taxes are taken into account.
Since index investing takes a passiveapproach, index funds usually have lower management fees and expense ratios (ERs)than actively managed funds. The simplicity of tracking the market without a portfolio manager allows providers to maintain modest fees.Index funds also tend to be more tax-efficient than active funds because they make less frequent trades.
More importantly, index investing is an effective method of diversifying against risks. An index fund consists of a broad basket of assets instead of a few investments. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns.
For many index investors, the is the most common benchmark to evaluate performance against, as it gauges the health of the U.S. economy. Other widely followed index funds track the performance of the Dow Jones Industrial Average (DJIA) and the corporate bond sector.
Active U.S. equity funds have experienced outflows every year from 2015 to 2020, according to Morningstar, with most of that withdrawn money being plowed into passive funds.
Index Investing Methods
Purchasing every stock in an index at its given component weight is the most complete way to ensure that a portfolio will achieve the same risk and return profile as the benchmark itself. However, depending on the index, this can be time-consuming and quite costly to implement.
For instance, to replicate the S&P 500 index, an investor would need to accumulate positions in each of the 500 companies that are inside the index. For the Russell 2000, there would need to be 2000 different positions. Depending on commissions paid to a broker, this can become cost-prohibitive.
More cost-effective ways to track an index involve only owning the most heavily-weighted index components or sampling a certain proportion, say 20%, of the index's holdings. The most cost-effective way to own an index these days is to seek out an index mutual fund or ETF that does all of that work for you, combining the entire index essentially into a single security or share.
Limitations of Index Investing
Despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds are formedon a market capitalization basis, meaning the top holdings have an outsized weight on broad market movements. So, if, say, giants such as Amazon.com Inc. (AMZN)and Meta Platforms Inc. (META), formerly Facebook Inc., experience a weak quarter it would have a noticeable impact on the entire index.
This entirely passive strategy neglects asubset of the investment universe focused on market factors such as value, momentum, and quality. These factors now constitutea corner of investing called smart-beta, which attempts to deliver better risk-adjusted returns than a market-cap-weighted index. Smart-beta funds offer the same benefits of a passive strategy, with the additional upside of active management, otherwise known as alpha.
Real World Example of Index Investing
Index mutual funds have been around since the 1970s. The one fund that started it all, founded by Vanguard Chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost.
Over the years, the Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. For its Admiral Shares, the expense ratio is 0.04%, and its minimum investment is $3,000.
FAQs
Example of an Index Fund
As of March 2024, Vanguard's Admiral Shares (VFIAX) posted an average 10-year average annual return of 12.75% vs. the S&P 500's 12.78%—a very small tracking error.12 The expense ratio is low at 0.04%, and its minimum investment is $3,000.
What is the overview of index funds? ›
An “index fund” is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.
What is an index examples how it's used and how do you invest? ›
An index tracks the performance of a group of preselected investments, such as stocks. For example, the S&P 500 index tracks the performance of 500 of the largest U.S. companies. Investors gauge the performance of stocks, bonds or mutual funds by comparing them with the performance of an index.
How to invest in index funds step by step? ›
How to invest in index funds
- Review your finances and goals.
- Choose an index.
- Decide which index funds to invest in.
- Open a brokerage account and buy index fund shares.
- Continue to manage your investments.
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
How does index investing work? ›
Index funds don't try to beat the market, or earn higher returns compared to market averages. Instead, these funds try to be the market — by buying stocks of every firm listed on a market index to match the performance of the index as a whole. Because of this, index funds are considered a passive management strategy.
How do index funds make you money? ›
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
Do you pay taxes on index funds? ›
Index mutual funds & ETFs
Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
What are the pros and cons of index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
How does index fund work with example? ›
Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.
How can I directly invest in index funds? You can directly invest in index funds by opening and funding a brokerage account. All brokers allow you to directly buy shares of ETFs on the open market, and most allow you to directly invest in mutual funds if you prefer to use those.
What is an index for dummies? ›
In finance, it typically refers to a statistical measure of change in a securities market. In the case of financial markets, stock and bond market indexes consist of a hypothetical portfolio of securities representing a particular market or a segment of it. (You cannot invest directly in an index.)
Should a beginner invest in index funds? ›
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.
What to do before investing in index funds? ›
Further, since the index funds endeavour to replicate the performance of the index, returns are similar to those of the index. However, one component that needs your attention is Tracking Errors. Therefore, before investing in an index fund, you must look for one with the lowest tracking error.
How do you calculate index funds? ›
The NAV, or net asset value, price of an index fund is what the index fund is worth based on the value of the securities it holds. NAV is calculated by subtracting a fund's liabilities from its assets and dividing that value by the number of outstanding shares.
What is the most common index fund? ›
Market exposure: The most popular index is the S&P 500 index, but index funds track dozens of other indexes.
Is the S&P 500 an index fund? ›
The S&P 500 is an index, so it can't be traded directly. Those who want to invest in the companies that comprise the S&P must invest in a mutual fund or exchange-traded fund (ETF) that tracks the index, such as the Vanguard 500 ETF (VOO).
How do you tell if a fund is an index fund? ›
The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you'll pay.
What are the three index funds? ›
A three-fund portfolio is a portfolio which uses only basic asset classes — usually a domestic stock "total market" index fund, an international stock "total market" index fund and a bond "total market" index fund.
