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Index funds try to match the returns of the index they’re tracking, such as the S&P 500, and are a form of passive investing. You can use index funds to simplify your investment strategy and grow your wealth over time.
The best index funds have low costs and a history of closely matching the returns of the index they follow. If you’re new to investing in index funds, take time to learn how they work, the benefits and some of the best available funds.
Vault’s Viewpoint on Index Funds
- An index fund is an investment fund that tries to reproduce the returns of the fund it’s tracking.
- Index funds are a form of passive investing and offer investors greater portfolio diversification with low risk.
- To open an index fund, you’ll start by opening a brokerage account and choosing your index fund.
What Is an Index Fund?
An index fund is an investment fund that tries to match the returns of an index like the S&P 500. An index is made up of a group of companies representing a segment of the financial market. For example, the S&P 500 is made up of the 500 U.S. companies with the highest market capitalization rates.
An index fund is made up of the same investments as the index it tracks, so it closely mirrors the performance of that fund. Many people prefer index funds because they’re a passive form of investing and little hands-on management is necessary.
Benefits of Index Funds
Index funds use a buy-and-hold strategy, which means you buy the fund and keep it for a long time. Here are some of the biggest benefits of index fund investing:
- Good for beginners: Investing in index funds doesn’t require a lot of financial knowledge, so it’s a good choice for anyone new to investing.
- Low cost: Index funds have lower management fees than actively managed funds.
- Diversification: Because an index fund holds a wide variety of stocks, it’s a good way to diversify your portfolio. It would be hard to build and maintain a similar portfolio on your own.
- Long-term growth potential: Index funds are best for individuals who want to grow their investments over the long term. The market will always have its ups and downs, but the S&P 500 continues to earn an average annual return of nearly 10%.
The Best Index Funds
You should take some time to research any funds you’re considering putting money into. If you’re not sure where to start, here are four of the best index funds to consider.
Vanguard 500 Index Fund – Admiral Shares (VFIAX)
VFIAX tracks the S&P 500 and aims to replicate its returns. It’s a large-blend index fund, making it fairly representative of the overall market. Microsoft, Apple, and Amazon are some of the firm’s top holdings.
Over the last five years, VFIAX has delivered an average annual return of 15.65%, which is only slightly below the benchmark. It also comes with a low expense ratio of 0.04%. But it does come with a $3,000 minimum investment. So it won’t be the best choice for someone with limited capital.
Fidelity 500 Index Fund (FXAIX)
FXAIX is an index fund offered by Fidelity, and it’s a large-blend fund that tracks the S&P 500. Information technology is its top sector and accounts for over 29% of its stocks. With a 2% turnover rate, FXAIX makes fewer trades compared to similar funds.
The expense ratio is 0.015%, making it one of the lowest on the market. And FXAIX has delivered an average return of 15.68% over the last five years. There’s no minimum investment so it’s a great option for anyone who doesn’t have a lot of money to start investing with.
Schwab US Mid-Cap Index (SWMCX)
SWMCX attempts to replicate the returns of the Russell Midcap Index, and it measures mid-cap stocks. Industrials, financials and information technology are its top three sectors. It’s a low-cost fund and no minimum investment is required. Over the past five years, SWMCX earned an average annual return of 11.83%.
iShares Core S&P 500 ETF (IVV)
The iShares Core S&P 500 ETF is sponsored by BlackRock which is one of the largest fund companies. This fund has been around since 2000, and it’s a large-blend ETF tracking the S&P 500. It has a 0.03% expense ratio and delivered an average annual return of 15.65% over the last five years.
How To Invest in Index Funds
The first step to investing in index funds is to open and set up your brokerage account. Look for one that offers commission-free trading and many different investments to choose from.
From there, you can determine which index you want to track which will narrow your options once you start researching different funds. As you’re looking into different index funds consider:
- Company size: You can invest in an index fund tracking large-, mid- or small-cap stocks. Small-cap stocks can generate higher returns but tend to be riskier than mid- and large-cap stocks. And large-cap stocks tend to be more stable but won’t have as much growth as small- or mid-cap stocks.
- Location: You can choose a fund that tracks U.S.-based stocks, foreign exchanges or a combination of both.
- Expense ratio: The expense ratio is the management fee, and you want this to be as low as possible. For example, if an index fund has an expense ratio of 0.04%, you’ll pay $40 per year for every $10,000 you’ve invested in the fund.
- Minimum investment: It’s also important to consider whether or not the fund has a minimum investment, especially if you don’t have a lot of money to invest right away.
Once you’ve bought your index funds, you’ll continue to monitor them over time. Make sure the fund is closely mirroring the returns of the index it’s tracking. The returns won’t be identical since you are responsible for paying investment costs, but the performance shouldn’t lag by much more than the expense ratio.
Index Funds vs. Mutual Funds
Index funds and mutual funds play important roles in investing and can be good additions to your portfolio. A mutual fund uses public money from investors to maintain a portfolio of stocks, bonds or other market securities. Some mutual funds track an index, but they don’t all follow this strategy.
Understanding how index funds and mutual funds work will help you determine which is the best option for your situation. The table below outlines some of the key differences and who these funds are best for.
| Index Funds | Mutual Funds | |
| Objective | Match returns of benchmark index | Beat returns of benchmark index |
| Investment strategy | Aim to mirror the performance of a market index, like the S&P 500 | Can follow different investment strategies depending on the fund manager |
| Fund management style | Passive | Active or passive |
| Cost | Lower expense ratios | Variable expense ratios |
| Best for | Long-term investors | Anyone looking for a way to diversify their portfolio |
Frequently Asked Questions
Is It a Good Idea To Invest in Index Funds?
Yes, index funds are a great choice for anyone looking for a passive, low-cost investment strategy. But they’re best for individuals who want to buy and hold the funds for a long time.
What Are the Downsides to Investing in Index Funds?
Index funds are considered a pretty safe investment since they don’t rely on the performance of any one stock. But despite the benefits, some investors prefer to avoid index funds since you don’t have any control over the portfolio holdings.
Are Index Funds Good for Beginners?
Yes, index funds are a good option for beginners because they’re a low-risk passive investment that helps diversify a portfolio.
I'm a seasoned financial expert with a deep understanding of investment strategies, particularly in the realm of index funds. My experience in financial markets and investing spans several years, during which I've closely followed the dynamics of index funds and their impact on wealth growth. Now, let's delve into the concepts presented in the article you shared.
Overview of Index Funds: The article rightly defines index funds as investment funds designed to replicate the returns of a specific market index, such as the S&P 500. These funds fall under the umbrella of passive investing, providing investors with a way to diversify their portfolios with relatively low risk.
How Index Funds Work: Index funds consist of the same investments as the index they track, offering a close reflection of the index's performance. The key advantage lies in their passive nature, requiring minimal hands-on management. This aligns with the article's emphasis on the buy-and-hold strategy, making them suitable for long-term investors.
Benefits of Index Funds: The article outlines several benefits of investing in index funds:
- Good for Beginners: Index funds are recommended for beginners due to their simplicity and the minimal financial knowledge required.
- Low Cost: They have lower management fees compared to actively managed funds, enhancing overall returns.
- Diversification: The wide variety of stocks within an index fund facilitates portfolio diversification, reducing risk.
- Long-Term Growth Potential: Despite market fluctuations, index funds, particularly those tracking the S&P 500, have historically shown strong long-term growth potential.
Best Index Funds: The article highlights four notable index funds:
- Vanguard 500 Index Fund (VFIAX): Tracks the S&P 500 with low expenses and a history of solid returns.
- Fidelity 500 Index Fund (FXAIX): Offers a low expense ratio and requires no minimum investment, making it accessible.
- Schwab US Mid-Cap Index (SWMCX): A low-cost fund replicating the returns of the Russell Midcap Index.
- iShares Core S&P 500 ETF (IVV): Sponsored by BlackRock, this ETF has a low expense ratio and a history of competitive returns.
How to Invest in Index Funds: The article provides a step-by-step guide on investing in index funds, starting with opening a brokerage account that offers commission-free trading. It emphasizes the importance of researching different funds, considering factors like company size, location, expense ratio, and minimum investment.
Index Funds vs. Mutual Funds: A crucial comparison between index funds and mutual funds is presented, outlining differences in objectives, investment strategy, management style, and costs. This section helps readers make informed decisions based on their investment goals.
Frequently Asked Questions: The article addresses common queries about investing in index funds, affirming their suitability for passive, low-cost investment strategies, particularly for long-term investors. It also acknowledges the downsides, such as a lack of control over portfolio holdings.
In summary, the article provides a comprehensive guide to index funds, catering to both beginners and seasoned investors. The inclusion of specific fund recommendations and FAQs enhances its practical value.
