What Every First-Time Investor Should Know about Index Funds

Index funds are a very widely-used tool among investors, particularly first-time or novice investors, and they receive a lot of positive press for offering a lower-cost, lower-risk way for investors to access popular stock and bond market indexes. But as with any investment tool, index funds can benefit a successful investment plan most when investors understand what they are, how they work, and what their benefits and drawbacks can be. Read on for a closer look at some of the most important things new investors should know about index funds.

What is an index fund?

An index fund is a type of passively managed mutual fund that tracks a particular index and attempts to mimic its performance. For example, an index fund that tracks the well-known Standard & Poor’s 500 index would own all the same stocks as those encompassed by the S&P 500; investors who invested in the index fund would therefore have a little bit invested in each of the S&P 500 stocks, and their returns would be based on the overall performance of the S&P 500.

Why do investors choose index funds?

Index funds operate on the principle that tracking market performance gives better results over the long term than a more active approach that attempts to “beat” the market. In broad terms, this usually means that investors will see lower returns over time, but those returns tend to be more consistent and less risky than those offered by other investment tools.

Another reason for the popularity of index funds is their relatively low expense ratios (the annual fee that investors pay to cover a mutual fund’s operating costs). Index funds typically have expense ratios of around 0.2–0.5%, whereas actively managed funds can see expense ratios of 1.3–2.5%, or sometimes even higher.

Here are some things to remember if you’re considering index funds:

Index funds are not always inexpensive.

Although index funds typically have lower expense ratios, this doesn’t mean they always do, or that they are always a cheaper option. Some index funds, especially proprietary funds provided by insurance companies or brokerage firms under a 401(k) plan, can have expense ratios of 1% or higher, so investors shouldn’t assume that index funds are automatically low-cost.

Not all indexes are equal.

An index, as mentioned, is a kind of tool for market measurement and analysis; it is this underlying index that an index fund tracks. But while some indexes are widely used and considered to be reputable, there are many indexes currently in use that were created using back-tested historical results rather than being based on real market data. Investors should be careful about index funds that use these types of indexes, as the simulated results may not accurately portray the risks involved.

Index funds are not risk-free.

This is an important concept for investors to understand: index funds generally offer a lower level of risk than other types of investments, but no investment is completely risk-free. With index funds, the risk is that your investment will be impacted by events that affect the market as a whole; for example, during the 2008 financial crisis, investors in index funds tracking the S&P 500 saw significant losses due to the overall decline of the underlying index. However, the type of risk that is eliminated with index funds is manager risk, or the risk that a manager’s investment style or investment choices will cause the fund to underperform. Because index funds are passively managed, this element of individual choice in securities selection does not apply.

Underlying indexes may change.

As mutual fund providers continue to compete with each other to offer investors the best price, it is becoming more common to see providers switching the underlying indexes that their index funds are tracking (this is often due to the fees that mutual fund providers must pay to the index providers). This does not necessarily have an adverse impact at the individual investor level, but it is important for index fund investors to keep a close watch on their holdings to ensure that such changes aren’t happening without their knowledge, and that they continue to understand exactly what they are investing in.

Index funds do not guarantee investment success.

Index funds have many advantages, certainly, but in the end they are simply a tool, just like any other investment product, and whether they provide the kinds of benefits you are looking for as an investor depends on your investment strategy. You should therefore be sure to carefully consider how index funds could fit in with your overall asset allocation plan rather than assuming that index funds alone are the path to investment success.