What is an index fund? The name implies the answer, but there are some fundamental concepts to understand before buying an index fund as an investment.
For instance, while indexing can be an effective and inexpensive way to invest, not all index funds work the same way. Their costs and structure can vary.
In the simplest sense, an index fund is an investment fund that attempts to replicate the performance of a given index of stocks or some other investment type. That can include bonds or even a narrow subset of a financial market, say, small-cap biotech companies.
Most index funds work by identifying an already well-known index, usually maintained by a respected third party, then building a fund that either owns every asset in the index or achieves the same end by holding similar securities.
Since an index fund owns all of the investments in the index, there is no picking winners and losers. As result, there’s also much less work in maintaining an index fund. That results, normally, in much lower costs for the investor.
Index funds are extraordinarily cheap: As a low as 0.05%, but in some cases they charge fees closer to those you would expect from actively managed funds, perhaps 1.5% or more. Kind of senseless, but such funds exist.
Disadvantages of index funds
It sounds like a good way to diversify, and it is, but there are some disadvantages to using index funds. For instance, if you buy a typical index fund through a brokerage you can expect a stiff commission, perhaps $50 each way.
Like mutual funds, index funds are traded in units and settle at the end of the day. If you plan to trade the index, this is an expensive and costly way to do it.
Of course, you could buy index funds managed by your own brokerage and, as s result, avoid the commission. Likewise, end-of-day clearing is meant to be a hurdle. Index fund managers want their customers to buy and hold, not trade willy-nilly. That’s not bad advice.
Finally, owning a broad index of stocks is not a substitute for true asset allocation planning. For that, you need a collection of different index funds that reflect the world as it is, including foreign equities, real estate, fixed income and commodities.
Why buy an index fund?
An investor who seek a cheaper, better way to own exposure to a given part of the market would do well to consider using an index fund. Lower costs contribute to long-term success in investing, and that’s the pitch from the index investing community. Buy the market, not the stock, and enjoy the advantage of keeping more of your money to compound into wealth.
If you trade your account a lot, however, then an index fund by design will be an expensive way to invest. In practice, though, they remain a great tool for the long-term thinker who wants a solid investment at a rock-bottom price, with no bells or whistles attached.