What is an Index Fund?

The past half century has been a great one for the individual investor. In that time, an investment vehicle known as an Index Fund was introduced, became more efficient, became widely available, and has become less expensive (and in some cases nearly free) to trade and own. In the past several years, this type of fund has found its way into many workplace retirement plans as an investment choice and is available at nearly every major online brokerage platform.

Jack Bogle, founder of The Vanguard Group (commonly referred to simply as Vanguard), is credited with beginning the first index fund. He passed away in January of this year and praise came in from across the financial industry.

So, what is this type of investment that Mr. Bogle brought us?

First, to understand an index fund it’s important to understand an index.

A stock index is a sampling of companies meant to be representative of the overall stock market or a portion of that market. One of the oldest and most widely cited indices is the Dow Jones Industrial Average. When you hear that “The Dow” was up 100 points, it’s referring to that index. Another prevalent index is the S&P 500. Bogle’s fund was based upon this index.

The S&P 500 is fairly easy to understand—it’s the 500 largest publicly traded companies in the United Stated based on their market capitalization (total value of all outstanding shares of that company’s stock). If you were to look at the top holdings of the S&P 500 index you would see many household names such as Apple, Exxon Mobil, J.P. Morgan, and Microsoft. The larger the company, the more of the index it makes up. As companies grow and shrink, so too does their standing in the S&P 500 index.

An index fund is an investment vehicle that attempts to track the returns of a stock index, typically by owning all of the stocks within the index in the same proportion as their size would dictate. The Vanguard 500 Index Fund, which is what Bogle’s original fund became, is meant to track the returns of the S&P 500 index. Since its invention, the cost of owning an index fund has continuously decreased. It’s this cost (or lack thereof) that makes up an important part of the case for owning an index fund.

Because an index fund simply replicates the returns (before costs) of an index, it doesn’t have a manager or team of managers whose job it is to pick winners and losers. This is known as passive management. The other side of that coin is active management. As the name implies, funds that employ active management have a manager or team of managers to actively select which companies their fund holds. These managers may rely on research teams, statistical models, or some combination thereof. With the managers, and their research, comes cost. These people have to be paid. The people who provide them information have to be paid.

All of these paychecks add up to be part of the cost of owning that active fund and are reflected in various fees that are part of the fund’s structure. To the end investor, these fees cut into returns. That means that even if the fund slightly beats an index, the embedded costs of active management might mean that the investor in that fund realizes an after-fee return that actually performs worse than the index.

Index funds aren’t without their detractors. Those who don’t favor this style of investing point out that by design an index fund owns all of the bad (or poorer performing) stocks as well as all of the good ones. They also point out that the traditional index fund (like the Vanguard 500 mentioned above) tilts heavily, again by design, to huge companies, often referred to as mega-caps. This means that the performance of these companies can have an outsized impact on the performance of the index, and, consequently, the index fund meant to track it.

Index funds aren’t perfect, but they do provide a diversified, low-cost avenue to add stock market exposure to your portfolio. For long-term investors with the appropriate risk appetite, they can be an important tool in a wealth building toolkit.

Disclaimer: This article is generalized in nature and should not be considered personalized financial, legal, or tax advice. All information and ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.