Answers to all your burning questions…starting with
“what’s an index fund?”
Index funds, mutual funds and exchange-traded funds (ETFs) sound pretty similar on the surface, which can make it difficult for new investors to decide which fund to invest in. It also doesn’t help that people tend to use these words interchangeably…
Not to worry!
This article will set the record straight, so you can start managing your portfolio like a pro.
An index fund is…
A type of mutual fund or ETF that aims to match or track the performance of a stock market index.
What’s a stock market index?
Ignore the stock market part for now – you’re probably already familiar with indexes because they’re actually just averages. For example, if you and ten of your friends weighed yourselves and calculated the average weight of the entire group, that would be an index. As your weights changed, the index would change too.
Similarly, a stock market index is a mathematical average that can quickly tell you how a section of the stock market is doing. It tracks the performance of a set of stocks in order to represent market trends.
You may have heard of the S&P 500, which collects data from the top 500 companies in the U.S. across different sectors. Analysts consider the S&P 500 a good indicator of how the U.S. stock market is performing overall.
Indexes can also group stocks from the same sector or industry together to monitor the market on a smaller, more specific scale.
How do index funds work?
An index fund allows you to invest in the securities tracked by a particular index. The performance of the index fund, relative to the index, is monitored by a fund manager.
For example, an investor might choose an index fund that tracks the S&P 500 because they want their investment to match that index’s average returns (the amount of money made on an investment).
Index funds are considered a passive investing approach, since hands-on portfolio management is not required. While active funds (ex. standard mutual funds) rely on frequent trading to maximize returns, index funds are designed to match market averages, not beat them. They’re built to mirror the performance of the index.
ETFs and mutual funds
Index ETFs and index mutual funds – you guessed it – track indexes. But let’s start with the basics.
What’s an ETF?
An ETF is a collection of stocks or bonds purchased for one price. Instead of selecting and buying a variety of stocks separately, you get to buy them as a bundle – like buying cake mix instead of cake ingredients.
Investing in ETFs is usually a form of passive investing – most ETFs don’t require a fund manager to frequently buy and sell stocks. Instead, ETFs track indexes, industry sectors, or specific types of investments (often using computer algorithms).
Because they are passive investments, ETFs usually charge lower management fees than, say, a mutual fund (we’ll get there in just a moment). The ETF fee is called a management expense ratio (MER) and is written as a percentage of the fund’s total value. You don’t have to pay the fee directly – it’s deducted from your return.
One ETF can contain hundreds or even thousands of different assets – making investments potentially less risky through diversification. For a deeper dive into what it means to diversify your portfolio, check out this blog we wrote!
Additionally, ETFs can be bought and sold multiple times a day, just like stocks on an exchange (hence the name “exchange-traded” funds). They even have their own ticker symbols!
There are tons of different ETFs – sector tracking ETFs, international ETFs, commodity ETFs, thematic ETFs and, of course, index ETFs.
What’s a mutual fund?
Mutual funds collect money from more than one investor and pool it together to invest in assets (ex. stocks or bonds) — like how an office might pool their money to buy a lottery ticket and split the winnings. Splitting costs between multiple people can make the investment more affordable.
When you invest in a mutual fund you aren’t buying shares of the stocks in the fund – you’re buying shares of the mutual fund itself. Mutual fund shares are traded once per day at their closing price, which is called the net asset value or NAV. This is essentially a calculation of how much the assets contained within the mutual fund are worth (minus any liabilities).
A portfolio manager actively manages the mutual fund by buying and selling securities. When the portfolio manager sells an asset for profit, this gain is typically paid to the mutual fund’s shareholders.
On the other hand, assets that increase in value but aren’t sold will cause the NAV to increase. If the NAV increases from the price you bought your shares at, you can sell your mutual fund shares for a profit (called a capital gain) – just like any other stock.
Mutual funds also pay out dividends and interest, depending on which investments are held in the fund.
Like ETFs, one benefit of mutual funds is diversification. A single mutual fund can contain dozens or even hundreds of different stocks.
Mutual funds have relatively high fees (remember that MER we were talking about?), since you have to pay fund managers to do the heavy lifting for you. Over time, these management fees can eat into your returns.
Index fund pros and cons.
Index funds are attractive to first-time investors as well as experienced investors because they passively accumulate wealth. Passive investing aims to maximize returns over the long run by not buying and selling securities often, making index funds a solid option for long-term strategies.
Keep in mind: while mutual funds are usually active investments, and index funds and ETFs are usually passive investments, there are passive mutual funds that track indexes and actively managed index funds and ETFs that require a portfolio manager.
Benefits of index funds:
- Accessibility — Many index funds have low minimum investments (thanks fractional investing!) making them accessible to beginner investors. In fact, you can invest in index ETFs using Flahmingo for as little as $1!
- Lower costs – Most index funds are passive (although there are active index funds) and passive investing generally requires less fees and lower MERs because active management isn’t required. Still, keep in mind that not all index funds have lower costs than actively managed funds.
- Diversification — I know, we’ve mentioned diversification a lot…but its benefits truly can’t be understated. It’s less risky to spread your money out across different industry sectors or companies, rather than going all in on a couple stocks (and easier than predicting how specific stocks will perform).
Drawbacks of index funds:
- Not flexible — Index funds track a specific set of companies; you can’t add or remove companies based on your preferences, so choosing the right index fund is key!
- Low risk, low reward — Index funds are considered low risk because they aren’t trying to beat the market and low reward because they typically invest in well-established companies with steady, modest growth. In other words, you’re not taking a shot on a new company with the hope of making a massive return.
- Tracking error — Low risk doesn’t mean zero risk; an index fund doesn’t always perfectly track its index. For example, if a fund only invests in some but not all the securities in an index, the performance of the fund is less likely to match the performance of the index.
How to invest in index funds.
You can invest in index ETFs using Flahmingo!
Step One: Fund your Flahmingo account.
Step Two: Create a Pie (in other words, a portfolio). Your Pie can be named whatever you like – whether it's the goal you're investing toward (Vacation Pie) or the industry you're planning to invest in (Tech Pie).
Step Three: Choose your Slices (stocks or ETFs). You can add up to 100 Slices to your Pie!
Step Four: Choose the dollar amount you'd like to invest in your Pie, and specify how you'd like that money split between Slices.
For example, maybe you invested $100 in your Pie, and you'd like that money divided evenly between five Slices. That would mean 20% of your total dollar amount is allocated per Slice.
Step Five: We'll invest your money based on the percentages you chose and confirmed.
Investing for the long term.
Index funds don’t require day-to-day maintenance – but that doesn’t mean you should invest in an index fund and forget about it. Investing incremental amounts regularly is one way to grow your investment over time.