What is an index fund and why do they matter to beginner investors?

There’s lots of talk about index funds, but what exactly are they? And why are they so popular?

The following article will take a deep dive into index funds, including what they are and why they are an excellent choice for beginners. Read to the end to ensure you understand what to look for when choosing an index fund for your portfolio.

What’s an Index Fund?

To understand an index fund, it’s best to first break it down.

Index: In finance, an index is a statistical measure of change in a basket of securities, like stocks. For example, the S&P 500 is an index of the 500 largest publicly traded companies in the United States. It provides a means to assess the change in price or value of the largest companies listed on stock exchanges in the U.S.

Fund: For this article, a fund specifically refers to an investment fund. An investment fund is a financial product that pools money from multiple investors and invests the proceeds with a specific strategy or objective. These funds can be managed by individuals, companies, or even governments. The most common types are mutual funds and exchange-traded funds (ETFs).

An index fund, therefore, is a type of mutual fund or ETF designed to replicate the performance of a specific index, like the SPDR S&P 500 ETF Trust, which seeks to track the returns of the S&P 500. While the construction can vary, a typical index fund will replicate the performance of an index by purchasing the underlying stocks in proportion to their weight in the index.

For example, imagine there was a fund called the XYZ Index Fund. This fund tracks the performance of the XYZ index. This index comprises ten stocks that happen to have the same market capitalization (total dollar market value of the company’s outstanding shares). That means each stock represents 10% of the index.

The XYZ Index Fund uses investor cash to purchase the same stocks at the same weight in the index. For example, if you invest $1,000, the fund managers would buy $100 of each stock (10% of $1,000).

Think of it this way: when you buy an index fund, you’re purchasing exposure to all of the index’s underlying stocks at their current weight. If you buy the SPDR S&P500 ETF, you’re investing in the 500 largest companies in the U.S.

Index Mutual Funds versus Index Exchange Traded Funds

While both products – or financial instruments – are index funds, they possess key differences.

	Mutual Funds	ETFs
Trading & Liquidity	A mutual fund’s units (representing your ownership of the fund’s pool of assets) are bought and sold at the end of each trading day. The unit prices are calculated once daily following market close.	ETFs are traded directly on an exchange, just like the underlying stocks they hold. As a result, shares of ETFs can vary throughout the trading day. Also, since ETFs are traded, their value does not necessarily reflect the value of the underlying stocks (it can sometimes be higher or lower).
Minimum Investment	Mutual funds typically have minimum investment amount requirements, ranging from a few hundred to several thousand dollars.	Typically, there is no minimum investment requirement with ETFs.
Fees	Mutual funds may include load fees (sales charges) and higher expense ratios than ETFs. Some mutual funds also include 12b-1 fees (marketing and distribution fees).	Usually, there are lower expense ratios and no load fees. However, depending on the broker, investors may incur a small commission to buy or sell ETF shares.
Tax Efficiency	Mutual funds may distribute capital gains to investors, resulting in a taxable event.	While the exact mechanism is beyond the scope of this article, ETFs are generally considered more tax-efficient than mutual funds due to their “in-kind creation/redemption” process. This process helps reduce capital gains distributions.

Active vs. Passive Management

Index funds are, by nature, passively managed. This means the fund manager does not make “active” investment decisions. Instead, holdings of the fund are dictated by the weight of each security in the index.

Active Management

Active management seeks to outperform the market (or a particular index) by making investment decisions based on analysis and expertise. To do this, active managers make frequent buying and selling decisions based on their research and current market conditions.

Since active management is much more resource-intensive, actively managed funds typically cost more than passively managed funds.

Passive Management (Index Funds)

Index funds are passively managed. Passive management aims to replicate or mirror the performance of a specific index. Outperformance is not the goal; replication is.

Why are Index Funds Suitable for Novice Investors?

Index funds are widely considered suitable for novice investors for their inherent diversification, low costs, and ease of management.

Diversification: Diversification is a crucial tenet of reducing risk in conventional portfolio management. Index funds can provide exposure to a broad range of assets, like the 500 largest publicly traded companies in the U.S. Despite only investing in one fund, you can access a diverse portfolio of stocks or other securities. This helps limit the risk associated with overconcentration in a single name.
Lower Costs: Index funds often have lower expense ratios than actively managed funds. Moreover, transaction costs are lower since they usually trade less than active funds. Ultimately, this helps investors keep a greater share of returns.
Risk Mitigation: The diversification of index funds can help offset poor-performing individual investments, thereby mitigating risk.
Ease of Management: Index funds are one of the most straightforward investment products in an industry known for complexity and a lack of transparency. They require little to no ongoing management from the investor, making them ideal for new investors.
Long-Term Investment: Index funds are often considered ideal as long-term investments. This is because, over time, the stock market has historically appreciated. As a result, investors can “set it and forget it” under the assumption the market – while volatile at times – will continue to increase in value.
Accessibility: Index funds – especially ETFs – often have low minimum investment requirements, making them accessible to nearly every interested investor. They are also typically widely available across investment platforms.
Dollar-Cost Averaging: Novice investors can benefit from using dollar-cost average (DCA) strategies with index funds. This strategy entails a recurring fixed-dollar investment, regardless of share price. The idea is that DCA spreads risk over time. As a novice investor, you won’t have to worry about timing the market. Instead, you maintain a disciplined and recurring contribution, expecting the investment to climb over time.

Historical Performance

Over the past three decades, on average, the S&P 500 index generated a compound average annual growth rate of 10.7% per year. While it’s an impressive return, you may be asking, why not opt for an active fund whose goal is to beat this performance?

The reason is simple: after accounting for added fees, most active managers don’t outperform their benchmark.

In other words, most active managers can’t beat a novice who buys index funds.

In fact, it’s not even close. Over a 20-year period, 95% of large-cap actively managed funds underperformed their benchmark. You read that right: after accounting for fees, 19 out of 20 active managers did not beat their index benchmark, like the S&P 500.

Accumulation vs. Distribution Index Funds

	Accumulation Funds	Distribution Funds
Purpose	Investors typically select accumulation funds when seeking capital growth (i.e., they wish to see the asset appreciate and are not concerned with periodic income payments).	Alternatively, distribution funds are designed for those who wish to receive regular income from their investments.
Reinvestment	When income – like a dividend payment – is generated on an underlying stock, it’s automatically reinvested (i.e., the proceeds are used to buy more shares).	There is no reinvestment of income with distribution funds. Instead, income is distributed to investors, usually monthly or quarterly.
Ideal For	Investors who don’t require regular income. Instead, it’s best for those focused on long-term growth, like someone just starting their career.	Investors who rely upon their investments for income, like retirees.
Tax Implications	When the fund is ultimately sold, capital gains taxes may need to be paid.	Income tax may be payable on the recurring distributions.

Choosing a Fund: What to Look For

When choosing an index fund, there are several factors you should consider.

Index: What type of index do you want to track? For example, you can choose a fund that tracks the broad equity market or a fund that focuses on a narrow sector, like technology stocks.
Cost: How much does the index fund cost? Is there a comparable fund with lower fees?
Performance: How closely has the fund replicated the index it’s attempting to track?
Liquidity: Higher average daily trading volumes typically imply higher liquidity. Generally, more liquidity is positive, allowing you to buy and sell funds without substantially impacting its price.
Tax: If tax efficiency is a concern, you might want to opt for an ETF over a mutual fund, for example.
Diversification: Does the fund offer you sufficient diversification?
Minimum Investment: Does the minimum investment requirement align with your investment capacity?

Popular Index Funds

Investors now have access to well over 100,000 funds. As a result, choosing the right one can be overwhelming. To help, here are some of the most popular index funds you access today.

Vanguard Total Stock Market Index Fund Admiral Shares

Product: Mutual fund
Mandate: Provide investors exposure to the entire U.S. equity market.
Minimum Investment: $3,000
Expense Ratio: 0.04%

BNY Mellon US Large Cap Core Equity ETF

Product: Mutual fund
Mandate: Match the performance of the Morningstar U.S. Large Cap Index.
Minimum Investment: $0
Expense Ratio: 0.00% (no expense ratio).

SPDR S&P 500 ETF Trust

Product: Exchange-Traded Fund
Mandate: Replicated the investment results of the S&P 500.
Minimum Investment: $0
Expense Ratio: 0.0945%

iShares Russell 2000 ETF

Product: Exchange-Traded Fund
Mandate: Track the investment results of the 2,000 small-cap domestic stocks listed on the Russell 2000.
Minimum Investment: $0
Expense Ratio: 0.19%

While index funds don’t guarantee financial success, they are one of the most effective ways retail investors accumulate wealth throughout their lifetime. The products are straightforward, accessible, and inexpensive. Consequently, they’re an excellent choice for novice and seasoned investors alike.

Regardless, if you’re unsure whether an index fund makes sense for your portfolio, consider speaking with a financial advisor. A professional can guide you through the various options while considering your unique needs and goals. Importantly, an advisor can address any concerns and offer peace of mind in your ultimate decision.