How To Use Index Funds?

9 Min Read
Last Updated July 23rd 2021

Most of you must have heard about index funds, chances are that many of you might not have invested in them. Warren Buffet, who is undoubtedly the most successful investor of all time invests in such funds. With an investment style based on value, patience, and discipline, he has often outperformed the market and has amassed a net worth close to $100 billion. Although you might not be able to invest the kind of money that Buffet invests, you can follow his recommendations and invest in low-cost index funds. Index funds are easy to invest in, carry low fees, and often perform very well, making them the smartest investment you can make.

That brings us to the all-important question – what is an index fund and how to use them? 

What Is An Index Fund?

An index fund is a form of a mutual fund or exchange-traded fund (ETF) that holds all (or a proportional sample) of the stocks belonging to a specific index. They aim to match the performance of the benchmark as closely as possible. The S&P 500 is possibly the most popular index. However, there are indices as well as index funds for almost all markets and investment strategies you can think of. It is possible to buy index funds directly from an index-fund provider or through your brokerage account.

When you purchase an index fund, you are diversifying your stock selection in one easy, low-cost investment. Certain index funds offer you exposure to thousands of stocks through a single fund, thereby lowering your overall risk through the diversification of your holdings. If you invest in various index funds tracking different indices, you will be able to build a portfolio that matches your preferred asset allocations. For example, investing in index funds allows you to put 40% of your money in stock indices and 60% in bond index funds.

It means that you can access a wider range of investment options at a lower risk through the index funds. Furthermore, when you invest in stocks on Wall Street, it is managed by fund managers who earn fat profits and not the investors themselves. It makes sense to invest in low-cost index funds not only because they don’t charge you through the roof, but also allow you to diversify with low risk.

If you feel index funds are your best bet, read on to know more about investing in index funds.

Key Points To Remember

Index funds are mutual funds or ETFs with portfolios that reflect the performance of a designated index, intending to match or beat its performance.

Over the long term, index funds generally outperform other types of mutual funds.

Index funds generally carry low fees, enjoy tax benefits (they result in less taxable income), and low risk (as they are highly diversified).

Why Choose A Fund Instead Of Individual Stocks?

An index is usually made up of hundreds and thousands of stocks. An average investor cannot afford to buy all or even a huge chunk of those stocks. Exchange-traded funds (ETFs) and mutual funds that stick to an index can buy all those stocks as they have access to larger pools of money collected from thousands of investors. And, when you buy a share of an index fund, you are owning every stock in that index.

Furthermore, all the funds weigh or rate their purchases. It means that they buy more numbers of some stocks than others. This is typical because the index counts certain stocks as more likely to affect the index than others. A good index fund will weigh its purchases to the same degree the index does.

An index is more likely to recover from a downturn than an individual stock. For instance, even if an index fund tracking the S&P 500 in 2008 would have lost, say approximately 38%, that same index rose by 325% by the beginning of 2018.

You must be thinking – does that mean there is a guarantee that the stock market will recover and the index you invested in will outperform it always? Well, anyone in the business of investment knows better than to make such a claim. However, the market has always recovered even after seeing some of the worst losses. Again, there is no guarantee that it will. But, the fact remains that there is a high chance of that happening and it offers the investors a much-needed reassurance.

Having said that, it is equally important to remember that if you are in the market for a short term, say five years or less, you could lose money if the index drops. This is because you are in the market for a short time and can’t afford to wait longer for a market recovery. As a result, index funds are considered the best options for long-term investment where you can stay invested for a period of at least six to ten years, if not more.

Sector Indexes

Indexes such as the Dow Jones Industrial Average and the S&P 500 are intended to track the stock market in general. However, you can also invest in funds that track a particular sector such as oil, finance, technology, consumer goods, and more. It is likely that you will find an index for whichever sector you can think of and that someone has created a fund that follows that particular index. If you think that a particular sector is likely to outperform the general market, you can buy a fund that tracks that sector and remain diversified within the sector.

This means that you have another way to diversify with index funds. When you invest in sectoral funds, you are still diversified. For instance, if your technology fund doesn’t fare well, chances are that another index fund, say oil, will. So, with index funds, you are not only diversifying within each sector but you are also invested in different sectors.

In this context, you must make sure that you know what each fund invests in so that you don’t end up with duplicate holdings. For instance, if you have invested in energy funds, you likely hold some stocks of an oil fund. Make sure you track these so that you don’t end up investing heavily in one type of fund.

The Benefits Of Index Funds

Better returns - As you might have already understood, there are several advantages to investing in index funds. The most obvious of them is that they consistently beat other types of funds in terms of total returns over the long term.

Lower fees – Another benefit of investing in index funds is the lower fees. Index funds usually carry lower management fees compared to other funds because they are passively managed. Index funds don’t have an actively trading manager or research teams to analyse securities and to make recommendations. Instead, the index fund’s portfolio merely duplicates the management of the chosen index.

Low transaction costs – Most index funds hold their investments until the index changes. As this is a rare occurrence, the transaction costs are low. This lower cost can make a huge difference to your returns over time, thereby helping you to earn more.

Less taxable income – Although index funds give you better returns over a long time, as they are traded in and out of securities less frequently, they generate less taxable income.  So, it means that the shareholders can enjoy the benefit of low taxes. As there are thousands of lots to choose from when you sell a particular security, you can sell them with the lowest capital gains and hence, benefit from the lowest tax rate.

As you can see there are several benefits of index funds. However, before choosing one, you need to compare their expense ratios as some of them can be way cheaper than others.

The Drawbacks Of Index Funds

Every investment has a downside. Index funds are no exceptions to this rule. One of the inherent drawbacks of index funds is that a portfolio will rise and fall with its index. So, if you are invested in a specific index, you’ll enjoy the benefits when the market does well. However, if things don’t go too well and the market drops, you will be vulnerable to losses too. This is mainly because index funds do not have an active manager to sense the market movement and steer the fund away from losses.

So, while it might be a good thing that you are not incurring more expenses when you stay invested in index funds, you miss out on the service of investment managers. Likewise, diversification, while being beneficial can also limit your upside. A broad-based collection of stocks in an index fund might be dragged down by few underperformers. This is quite contrary to the cherry-picked portfolios you can enjoy with other types of funds.

The Bottom Line

As you can see, index funds come with several benefits. However, they have some drawbacks too. To successfully invest in an index fund, you must understand what an index fund is and what are the pros and cons they carry. Generally, index funds are great investment opportunities, especially because they offer opportunities for diversification along with low expense ratios. However, with every investment in an index fund, you are also exposing yourself to the risks in that index. Index funds are best suited for long-term investment because low performance by one stock will be made up by the good performance by others in the index.

Lastly, it should be remembered that no active fund managers are managing these funds. So, a lot depends on the performance of the index. Hence it is up to you to choose the best index and make the best of your choices. You can stay invested for a long period and reap the benefits. If you are looking to make some profit in short term, index funds are not the right option for you. So, make your choice based on your requirements and willingness to stay invested for a longer-term.

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