What is an index fund? (And is it a good investment decision)

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    What is an index fund?

    When you dive into the world of investing, index funds will inevitably pop up on your radar. With the help of these funds, you can build up your portfolio relatively easily.

    But what exactly is an index fund? And why are so many investors fans of this type of investment vehicle? In this article, we’re going to explore all of these questions and more. Let’s begin!

    What is an index fund?

    An index fund is a form of investment that is geared towards following a specific benchmark of the stock market.

    The fund itself can pursue any particular selection within the financial market. For example, the S&P 500 is a common index on which a wide range of funds are based. Some of the index funds based on the S&P 500 are Vanguards VFINX, Fidelitys FUSEX and Schwabs SWPPX.

    Index funds can either be an exchange traded fund (ETF) or a type of mutual fund. As long as the fund is geared towards a certain segment of the financial market, it is considered an index fund.

    Advantages and disadvantages of index funds

    As with all financial products, you will find that index funds have advantages and disadvantages. Here’s what you need to know.

    advantages

    Let’s start with the benefits of working with an index fund.

    • Broad diversification– Index funds are designed to span a wide range of stocks and bonds by including each security in a specific index. Diversification can help you better weather the ups and downs of specific industries.
    • Lower taxes– Index funds are passively managed, which means that they do not buy or sell stocks as often as actively managed funds. With fewer sales events, you can potentially enjoy lower taxes.
    • Lower cost– The fees for passively managed funds are generally lower than for actively managed funds.

    disadvantage

    As with all financial products, investing in an index fund has some drawbacks. Here are a few things to keep in mind:

    • volatility– Compared to fixed income instruments like bonds, the stock market is inherently volatile. If you choose a fund that reflects part of the stock market, your portfolio will reflect that volatility.
    • No flexibility– The fund must follow the index. This means that fund managers have no flexibility to mix the investments within the fund.
    • Average return – This is also to be rated positively. It is important to note, however, that index funds are not the right choice if your goal is to “beat” the stock market.

    How do index funds compare to active funds?

    An index fund is often viewed as a relatively straightforward investment. They merely serve as a mirror of a particular component of the market. With that, their aim is to get the average for every benchmark they follow.

    Actively managed mutual funds, on the other hand, do not follow any particular index. Instead, they try to outperform the market. So how do these two funds fare against each other? Here’s a closer look at the performance and cost differences.

    performance

    If you just wanted to keep up with the market, an index fund would do. However, investors who choose actively managed funds are looking for outperformance. Is that what you get? It turns out that active funds don’t come out on top nearly as often as you might expect.

    In 2020, 60.33% of actively managed large-cap funds below average the S&P 500 according to SPIVA. And that in a year in which we experienced massive volatility due to the pandemic-related crash in March.

    Over three years, the proportion of actively managed funds that lagged the overall market rose to 69.71%. And for the five-year period ending December 31, 2020, a whopping 75.27% of active funds couldn’t keep up with the performance of the S&P 500.

    What is an index fund?

    Obviously some actively managed funds to do fall in the roughly 25% of funds that have outperformed the market over the past five years. ARK funds, for example, are very popular because of their reputation for consistently outperforming the S&P 500. The overall probability of this, however, is only any Active funds are not in your favor.

    costs

    When choosing funds for your growing investment portfolio, it is important to consider cost. After all, the goal of investing is wealth accumulation. You don’t want to overpay for fees that create strong headwinds for your investments that you have to contend with.

    Actively managed funds are regularly monitored by fund managers who have to make decisions about what to add to the fund. This includes hours of research, buying stocks, and selling stocks. All this effort has its price. The average expense ratio of an actively managed mutual fund is between 0.5% and 1.0%.

    On the other hand, index funds are relatively passive companies. The Fund is designed to reflect a specific index and buying and selling choices are limited to the constructions of the index. This makes them less labor intensive to administer and usually a lower cost option with average expense ratios of around 0.2%.

    If you accept the lower costs and potential errors of active management, you may find yourself drawn to investing in an index fund. And you wouldn’t be alone. In fact, for years, investors have been pulling out of actively managed funds in favor of low-cost passive funds that promise to keep up with the market.

    Final thoughts

    An index fund can be a useful tool to help you build a portfolio that is geared towards meeting your investment goals. If you’re content with keeping up with the market instead of trying to beat the market, then an index fund is an easy choice.

    Some of our favorite stock brokers for investing in DIY index funds are Vanguard, Fidelity, and Charles Schwab. Or if you still feel like one little If you want to help with your investments, consider opening an account with one of our top robo-advisors, most of whom build their portfolios on the foundation of index ETFs.

    Would you like to explore your other investment options? Check out our ten best ways to invest with just $ 1,000.

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