What Is An Index Fund?


What is an index fund simple definition: An index fund is a portfolio of stocks or bonds designed to mirror the makeup and performance of a financial market index.

To mimic, simulate, and closely resemble an index market like the Standard and Poor’s 500 Index or the Dow Jones Industrial Average.

An index fund is a pooled investment vehicle that passively seeks to replicate the returns of some market index like the S&P 500 and/or the DJIA.

Owning an index can only be accomplished indirectly since it’s not possible to own an index because an index is basically an imaginary portfolio of securities representing a particular market or a portion of it.

An index mutual fund can provide broad market exposure, include low operating expenses, and have a low portfolio turnover.

An index fund follows their benchmark index regardless of the state of the markets. As the index market the fund is following changes, so shall the index fund.

A manager must go in and change the allocation of the index fund to match the index market it imitates.

Mirroring or mimicking the actual indexes is most commonly accomplished through index funds & ETFs (exchange traded funds.)

We can also do it either through self indexing or index derivatives but to keep it simple we will only talk about index fund investing in this article.

How Does An Index Fund Work?

“Indexing” is a form of passive fund management. It is where the fund manager builds a portfolio where the holdings mirror the securities of a particular index.

We take this strategy rather than actively stock picking and trying to time the market. It’s the opposite of day trading, that is choosing securities to invest in and strategizing when to buy and sell.

By mimicking the profile of the index of the stock market as a whole, or a broad segment of it, the fund will match and mirror its performance.

Where Did The Idea Of Index Funds Come From?

The creator of index funds is the late Jack Bogle. He devised the index fund in 1975 as a way for retail investors to be able to compete with the pros.

Rather than put together a group of stocks into a mutual fund hoping to beat the market, Bogle found a way for investors to approximate the performance of the market.

They could do this at a much lower cost than the mutual fund, which has higher fees.

Jack Bogle had many critics, and it took a quite a while for the strategy to catch on in the mainstream. The idea would soon revolutionize investing dramatically.

What Exactly Is An Index And How Does It Work?

An index is an indicator or measure of something. In finance, it typically refers to a statistical measure of change in a securities market.

With financial markets, stock and bond market indexes comprise a hypothetical portfolio of securities representing a particular market or a segment. (You cannot invest directly in an index.)

The S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index are common benchmarks for the U.S. stock and bond markets, respectively. Regarding mortgages, it refers to a benchmark interest rate created by a third party.

Each index related to the stock and bond markets has its own calculation method.

In most cases, the relative change of an index is more important than the actual numeric value representing the index.

For example, if the FTSE 100 Index is at 6,670.40, that number tells investors the index is nearly seven times its base level of 1,000.

However, to assess how the index has changed from the previous day, investors must look at the amount the index has fallen, often expressed as a percentage.

Is It Good To Invest In Index Funds?

Investing in an index can only be done indirectly, but index mutual funds and ETFs are now very liquid in the case one would need to cash out in an emergency.

They are cheap to own and often come with zero commissions. They are what we can call a set-it-and-forget-it investing option.

Index fund investing is the best and safest way to go. It’s the closest thing to passive investing there is.

If you have time to read a brilliant book on how to allocate and manage your portfolio, then pick up a copy called The Simple Path To Wealth by J.L. Collins.

He started blogging many years ago about investing and wrote many articles to his daughter about how she should manage her money. After years of accumulated writings, he compiled his articles into this outstanding book with tons of wisdom.

What Are The Returns Of An Index Fund?

Like all stocks, the S&P 500 will fluctuate. Over time, however, the index has returned about 10 percent annually.

That doesn’t mean index funds make money every year, but over long periods of time that’s been the average return of an S&P 500 index fund.

Over long periods of time, the index typically produces better returns than actively managed portfolios, especially after considering taxes and fees.

The S&P 500 Index continues to be alluded to as the standard by which we measure all investment performances.

They pay investment managers a lot of money to generate returns for their portfolios that beat the S&P 500.

It needs to be said that on average, less than half do so.

In his 2014 annual letter to shareholders, Warren Buffett included an excerpt from his will that ordered his children’s inheritance to be placed in an S&P 500 index fund because the “long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals who employ high-fee managers.”

Can You Lose Money In An Index Fund?

No one can truly predict what the stock market will do, and yes, an investor can lose money just like any other investment in the financial markets.

It’s good to note that there is almost zero chance any index fund could ever lose all its value.

This is because index funds are low-risk investments. People who invest in them will not make the large gains they might from high-risk individual stocks. Yet conversely they wouldn’t lose all they have either.

The investing strategy to follow with index fund investing is to be in it for the long term. The market goes up and comes down.

Historically, it’s always went up more than it has gone down. When your index fund investments are in a down cycle, don’t panic.

It’s actually a good thing because that is a time to be investing more money and doing what Warren Buffett calls getting the equities on sale.

As far as single stock investing strategy goes, it’s best to glean from what the Vanguard creator himself said as we alluded to Jack Bogle earlier in this article.

He recommended never using over 5% of your total portfolio value to invest in individual stocks.

I would call this the play money. Sort of like gambling money one would take to Las Vegas on a weekend.

What Index Fund To Invest In?

After lots of research and careful consideration, I would personally choose the Vanguard (VTSAX).

It’s the Vanguard Total Stock Market Index Fund. It began trading in 1992.

The Vanguard Total Stock Market Index Fund provides investors with exposure to the entire U.S. equity market, including small, medium, and large-cap growth, including value stocks.

The fund’s key attractions are its low costs, broad diversified characteristics, and for its tax efficiency.

Investors looking for a low-cost way to gain an overall exposure to the U.S. stock market who are willing to accept the volatility that comes with stock market investing may want to consider this fund as either a core investment or the only domestic stock fund in their investment portfolio.

There is a minimum amount to invest. At the time of this article, it is $3,000 to get started. You can be certain Vanguard is among the lowest in fees and the actual creator of index funds with its founder, Jack Bogle.

Another substantial fund is Vanguard S&P 500 ETF (VOO). As its name entails, the Vanguard S&P 500 tracks the S&P 500 index, and it’s one of the largest funds on the market with hundreds of billions in the index fund.

This ETF began trading in 2010, and it’s backed by Vanguard, the creator of the index fund and still one powerhouse of the fund industry.

Martin Hamilton

Martin Hamilton is the founder of Guiding Cents. Martin is an Author, Entrepreneur, Marketer, Financial Researcher & Investor. He is a long time Mortgage Planning Consultant & Licensed Real Estate Agent.

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