Index Fund | Definition

/ˈinˌdeks fənd/

tracks the performance of stocks | 401(k) | wealth | grant | bank | bond | spac | definition swithin an index, such as the S&P 500; a  portfolio of  stocks and  bonds that perform similarly to a financial market index

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When beginning to invest, there are many different avenues that one could pursue. For example, a person could open a brokerage account and start investing in various stocks, bonds, and cryptocurrencies–such as Bitcoin, Ethereum, and NFTs. However, one key issue when investing in stocks is that it can be challenging to determine which individual stocks are best to invest in and are the best to hold onto for the long term. Therefore, some investors turn to index funds for many reasons, including the lack of expertise or uncertainty regarding which stocks to invest in.

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How an Index Fund Works

Index funds track the performance of some of the biggest public companies and invest accordingly in them to mimic a similar level of growth or decline. Typically, index fund returns for investors are lower than the mimicked indexes as a minor portion of the profits will be retained by an asset management company. 

To invest in an index fund, an investor gives money to an asset management company, such as Vanguard. The company then takes the investor's money and begins investing it in the companies their index is following. 

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Index Funds vs. Mutual Funds

Fund management is the main difference between an index fund and a mutual fund. In fact, an index fund is a type of mutual fund. 

Mutual funds have many analysts who research different stocks endlessly to determine when to buy and sell stocks to maximize their investment profits. Therefore, this type of active management requires a lot of manpower. As a result, the expense ratio, which is the fees associated with a third party controlling your investments, is much higher than an index fund.

On the other hand, index funds require less staffing since they are passively managed. 

An index fund tracks the performance of stocks within an index, such as the S&P 500, by purchasing shares of companies within that index. Index funds can only buy the shares of the index tracked. Typically, the companies invested in are the same, as it is very rare for the benchmark index to change. 

Pros of Index Funds

One of the main benefits of investing in index funds is fewer and less expensive fees. Unlike a mutual fund, an index fund tracks the performance of a specific index and does not try to exceed the average annual returns actively. Therefore, as fewer analysts research how and when to purchase stocks to beat the market, index funds can offer lower fees to investors as they have fewer expenses to cover. 

Furthermore, another major benefit of index funds is their tax benefits. When trading within the stock market, the money earned from investments can be categorized into short-term and long-term capital gains. 

Short-term capital gains are profits made on less than one-year investments. The gain is taxed at your regular tax rate when profits are made on short-term investments. However, when profits are made on long-term investments, different tax rates are lower than the regular annual ones used when filing tax returns.

Cons of Index Funds

The main disadvantage of investing in index funds is the lack of flexibility. Similar to the current economic conditions, there will be times in the future when the stock market will begin to decline in value for a period of time. Typically, investors will start liquidating their investments when they realize the market is crashing.

However, as index funds have very infrequent transactions, this may lead to some portfolio managers not selling their positions in companies during a stock market decline. Consequently, this may potentially lead some investment values to decrease, which may frustrate investors.

Examples of Index Funds

One example of an index fund is Vanguard S&P 500 ETF (VOO). The index fund tracks the Standard and Poor's 500, also known as the S&P 500. The S&P 500 focuses on 500 US companies with the highest market capitalization on the stock market.

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Another example of an index fund is the Dow Jones Industrial Average, which tracks the daily performance of 30 large-cap companies that are traded on the New York Stock Exchange (NYSE) or NASDAQ. 

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Regardless of the investment method a person chooses to pursue, there will always be risk involved. Therefore, investors should research the different investment methods and determine which one suits their risk style best. 

For example, some investors are more risk-averse than others, and therefore they turn to safer, less risky investments such as indexes and bonds. At the same time, those with a higher risk tolerance tend to invest in opportunities that have a chance of a higher payout but carry higher risk, such as penny stocks, cryptocurrency, and mutual funds.

Therefore, when beginning to invest, whether it be on your own or with the help of an asset management company, it is important to try and determine your risk tolerance, so you do not make poor financial decisions.

Disclaimer: The information in this article should not be considered as financial advice. Always do your research prior to investing. CapWay is not liable for any losses which may be incurred.

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