What Is an Index Fund
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation For example, you might put 60% of your money in stock index funds and 40% in bond index funds
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Index Fund Pros
Very low fees
Lower tax exposure
Passive management tends to outperform over time
Broad diversification
Index Fund Cons
No downside protection
Doesn't take advantage of opportunities
Cannot trim under-performers
Lack of professional portfolio management
What Are the Benefits of Index Funds?
The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return
One major reason is that they generally have much lower management fees than other funds because they are passively managed Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index
Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs Those lower costs can make a big difference in your returns, especially over the long haul
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter “A major reason has been fees Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers And that is a fool’s game ”
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What's more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders
Index funds have still another tax advantage Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite
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If you're shopping for index funds, be sure to compare their expense ratios While index funds are usually cheaper than actively managed funds, some are cheaper than others
What Are the Drawbacks of Index Funds?
No investment is ideal, and that includes index funds One drawback lies in their very nature A portfolio that rises with its index falls with its index If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it
It’s easy to fuss about actively managed funds’ fees But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market However, few managers have been able to do that consistently, year after year
Also, diversification is a double-edged sword It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside The broad-based basket of stocks in an index fund may be dragged down by some underperformers