Index fund: what is it, how and why to invest in it

Over the last decade, index funds have attracted well over a trillion dollars in net inflows in the United States alone, while more actively managed funds experienced an outflow of nearly the same amount. Around the middle of 2019, the value of equity funds tracking an index for the first time surpassed that of funds where stocks are actively picked. This investment trend is important but what exactly is an index fund? What are the pros and cons of investing in one, and how do you do it?

An index fund is a mutual fund (a financial vehicle that pools money from many different investors) that gains or loses money according to the performance of an underlying index, which is a standardized measurement of the price movements of a basket of securities. For instance, some index funds track the performance of the S&P 500, which is a benchmark of the 500 largest publicly traded companies in the United States. Index funds use a passive investment strategy, meaning investments are held regardless of market performance instead of actively trying use market timing to predict and profit from changes in value.

The theory behind index investing is that over the long term, the market will outperform portfolios actively managed by investors. This idea, which was pioneered over fifty years ago by figures such as John Bogle, first met with resistance or even derision, but has since gained traction and has been embraced by legendary investors like Warren Buffet. Since index investing is a form of passive investing, its expense ratios (the cost of managing funds in relation to the assets under management) are very low, which gives it a competitive advantage over active investors, who have to outperform the market by a large enough margin that they can also cover the higher costs of active management. Index funds also have very broad diversification built into them, so they are less susceptible to volatile shifts. They tend to yield the best results over long timeframes, so they are ideal approaches for individual investors saving for retirement, for example.

You can invest in index funds by directly buying shares of a mutual fund that tracks an index of your choice, be it equities or bonds, large-cap or mid-cap stocks, or emerging markets. Index funds usually have relatively large minimums for investing of a couple of thousand dollars or more. Another option for investing in index funds is through exchange-traded funds, commonly referred to as ETFs. An ETF based on an index fund offers the same diversification as the fund, but an ETF can be traded throughout the day like a stock, while a mutual fund cannot. The threshold for buying an ETF is usually lower than that of an index fund, at the price of one share, and ETFs can be more tax efficient than index funds in many cases.

Your choice of index fund will depend entirely on your investment goals and time horizon. If you are investing for a long timeframe, a growth-oriented index fund heavy on equities may be advisable, while a more conservative bond index fund may be better suited for medium-term goals.

Many index funds have a minimum that will often run around a couple of thousand dollars. However, you can enter index investing with significantly less capital using ETFs. Passively managed funds like index funds have low expense ratios of around 0.2%, meaning that for every dollar you invest, only two tenths of a cent will go toward covering the cost the funds management, advertisement, and other expenses.

Investing is an inherently risky activity, so theoretically you could lose all the principal you invest in any fund. But since an index fund usually represents a large swath of a market or group of markets, it would take a catastrophic crisis affecting many industries and sectors of society for you to lose a large portion of the money you invested.