Index Funds: What you need to know

What is an Index Fund?

An index fund is a type of investment that tracks a specific market index, like the S&P 500, or a sample of its stocks, with the goal of mimicking the performance of that index. There are index funds for various markets and investment strategies. You can buy them through a brokerage account or directly from providers like Fidelity.

When you invest in an index fund, you're purchasing a broad mix of stocks or bonds in one simple, low-cost option. Some index funds hold thousands of different securities, which helps spread out the risk. By investing in multiple index funds that track different indexes, you can create a portfolio that aligns with your investment goals. For example, you could allocate 60% of your money to stock index funds and 40% to bond index funds.

Index Fund: Advantages

• Low fees

• Lower tax impact

• Passive management often performs better in the long run

• Wide diversification

Index Fund: Disadvantages

• No protection against market downturns

• Misses out on potential opportunities

• Can't remove underperforming assets

• No professional portfolio management

What Are the Benefits of Index Funds?

The biggest advantage of index funds is that they tend to outperform other types of funds in terms of overall returns.

A key reason for this is their much lower management fees, as they are passively managed. Unlike actively managed funds that have a team of managers and analysts making decisions and buying/selling securities, an index fund simply mirrors the composition of a specific index.

Since index funds generally hold their investments until changes are made to the index, which is rare, they incur fewer transaction costs. These lower costs can significantly boost your returns over time.

As Warren Buffett noted in his 2014 shareholder letter, "Large institutional investors have often underperformed simple index-fund investors who hold their investments for decades. A major reason for this is fees: many institutions pay large sums to consultants who recommend high-fee managers, which is a losing strategy."

Additionally, because index funds trade less frequently than actively managed funds, they generate less taxable income, which means fewer taxes for shareholders.

Index funds also have a tax advantage. When new money flows into the fund, they buy additional securities from the index. With so many securities in the fund, they can choose to sell those with the smallest capital gains, minimizing the tax impact for investors.

What are the drawbacks of Index Funds?

No investment is perfect, and index funds are no exception. One disadvantage is that their performance directly follows the performance of the index they track. For example, if you invest in an S&P 500 index fund, you’ll benefit when the market is doing well, but you’ll also be fully exposed to losses when the market drops. In contrast, an actively managed fund allows the manager to adjust the portfolio in response to market changes, potentially avoiding or lessening the impact of downturns.

While the fees of actively managed funds are often criticized, a skilled fund manager can sometimes protect the portfolio or even outperform the market. However, finding a manager who consistently delivers strong results year after year is rare.

Another potential downside of index funds is that while diversification reduces risk by spreading investments across various assets, it can also limit potential gains. If some of the stocks in the index underperform, they can pull down the overall performance, unlike a more selective, actively managed fund that may avoid those underperformers.