What is an Index Fund and Why Should I Care?

I’m a huge fan of index funds. Before I started investing in index funds, I heard about them, but never understood what they were. I’d hear financial pundits say things like, “Most fund managers invest their own money in index funds.” Warren Buffet recommends long term investing into index funds. 

Huh? What?  They sound cool but what are they? (Okay, they don’t sound cool at all but still, what are they?)

Before we talk about what an index fund is (which is a specific type of mutual fund), let’s break it down even further. And a book I can’t recommend enough, that is the underpinning of my own index-education, is The Bogleheads’ Guide to Investing

A Stock (Ownership in a Company) Publicly Traded

A stock, that a person off the street can own (the general public), represents a piece ownership in a publicly traded company. There are a lot of privately held companies, and they have stock too, but they are owned by a tighter circle of people and their companies are not found on an exchange (a place where the securities are listed) like the New York Stock Exchange or the NASDAQ.

An index represents sectors of companies, like the DOW JONES, S&P 500 (the 500 largest U.S. publicly traded companies), and NASDAQ (usually tech companies).

You’ll see the various indices represented on the homepage of finance.yahoo.com and they’ll either be red (a down day in overall prices of the stocks on that index), or green (an up day in prices). You’ll see other indices like the RUSSELL 2000 which is an index measuring the performance of approximately 2,000 small-cap companies. If you scroll to the right, you’ll see other indices that represent a collection oil prices, gold prices, international prices, etc. For simplicity, we’re going to focus on a major index like the S&P 500.

Why Invest in Publicly Traded Companies (aka “the Stock Market”)

So when a company “goes public,” that means they’ve chosen to offer their stock (ownership in their company) for sale to the public and that stock will be registered with one of the exchanges. As such, they are now subject to the SEC (U.S. Securities and Exchange Commission) which means they have to submit mandatory material business and financial disclosures. The SEC is an independent federal government agency responsible for protecting investors, with an objective to maintain “fair and orderly functioning of securities markets and facilitating capital formation.” In short, everything you might want to know about a company, including how much their compensating their CEO, is available in their public filings.

Why does this matter to you? Because the oversight, in theory, protects you and you know what you’re getting and your shares are valued based on earnings. When your cousin, friend, brother-in-law comes to you with an “investment opportunity” they are not required to provide extensive filings and there seems to be little or no consequence if the business venture “didn’t work out.” You’re out the money and they may or may not feel awkward facing you at family reunions, depending on their level of sociopathy.

I’ve had more than my share of getting friends out of certain “investments.” A few were successful, but most were expensive lessons on not giving your hard earned money to friends or family to “invest.” Just. Don’t.

The more convincing they are, the faster you should be running.

Mutual Funds

Most of you have heard of mutual funds. A mutual fund indicates that a fund manager has hand-picked a group of stocks from several companies and put them into one basket. You can now buy a portion of that basket of funds by buy investing in the fund manager’s “mutual fund.” In other words, you don’t own stock in one company, rather, you buy the mutual fund and receive ownership in the whole basket of companies that are in that fund. The mutual funds have names like, the “McMega Large Cap Fund Yo.” The fund, like individual stocks, will have a ticker symbol: MLCFY.

A quick place to research a fund, via its name or ticker symbol, is at Morningstar.com (in upper right click “Direct to morningstar.com”). The basic information it provides is free. Morningstar.com gives star ratings, expenses, fee level, category (large blend), etc. and you don’t have to create an account to use the service.

Limited Options Through Employer Retirement Funds

If you’re in an employer plan, like a 401K or 457, you have limited options. Most of the offerings are various mutual funds that represent large cap companies, mid cap companies, small cap companies, international, bonds and REITS (real estate). Some are “balanced funds” which can connote a mix of stocks and bonds within the mutual fund. Janus used to have a balanced fund that I often invested in through my work 401K. Back then I didn’t know what it meant, but I liked that it had consistent returns. I believe Vanguard has a popular balanced fund. (Quick note: Avoid all the target funds “2035,” they notoriously underperform for some odd reason.)

So, if you’re investing through work, balance your investments between the various fund offering categories. Mutual funds are usually diversified among a category with multiple company holdings. A more detailed post on how to choose among your options is forthcoming, in the meantime, print out the MorningStar evaluations for each of the funds offered by your employer and compare them to others in the same category (bonds, large cap, small cap, etc.). Your company may or may not have index funds as one of its options. It’s getting more common, but often you just have to pick from among the managed mutual funds.

Index Funds

Finally, we’re here! Index funds! So exciting. Okay. So whereas a mutual fund contains hand-picked companies placed in a basket and you buy a share in that basket, index funds are passive picks. They mirror the S&P 500 or the NASDAQ (Apple, Tesla) indices. So if you own a Vanguard or a Fidelity S&P 500 index fund, you own all the companies in the same proportion as the actual S&P 500 index. It’s the benchmark. All other mutual funds are measured against it. But you know what the real gift of an index funds is? They are cheap (costs to manage is extremely low) and ultimately you keep more of your money because your investments are not eaten away by expensive fund management fees. Some fees are as high as 1-1.2%. So of every $10,000 you’ve invested, you’re paying $100 just in fund fees. If fees are 0.8%, fees would be $80 on every $10,000.

Enter a U.S. index fund: you’re often paying less than .04%. So of every $10,000 you’ve invested, your fees would be $4. Yes, $4.

And guess what else, hand picking funds is a fool’s game. Even if their fund can beat the relevant benchmark (the S&P 500, for example), they will only beat it one, maximum two years, out of ten. Stick with the benchmark. Be diversified. Pay low costs and fees.

In other words, when you open your first Roth IRA or have rolled over your 401Ks to a Vanguard or Fidelity IRA (I like both, recommend Fidelity for their great website interface, ease of use, and simple research tools linked to Morningstar; Vanguard is the granddaddy of index fund investing), choose  index funds over other managed funds in the same categories.  Jack Bogle, founder of Vanguard, and Warren Buffet would both be fans of any S&P 500 index fund managed by a major brokerage house (like Vanguard or Fidelity).

My Own Index Funds

In my Roth IRA with Fidelity, these are two of my index funds: Fidelity Total Market Investor Class (FSTMX), this is an index that mirrors the whole market, large, mid and small cap stocks. The fees are .015%. That’s $1.5 per $10,000. I also have a NASDAQ index fund (I was a tech attorney, so I’m very comfortable investing in tech stocks), Fidelity Nasdaq Composite Index Fund (FNCMX). It’s more volatile and costs a bit more, 0.42% fees, around $42 per $10,000, but I’ve like the aggressive nature for my Roth IRA that I’ll never pay taxes on again. My CPA gave me great advice when he notice I had my Roth invested in a lot of bonds (slow growth, ho hum returns). He said, “You won’t pay taxes on any of those gains, so why not invest more aggressively in your Roth?” So now any bond funds I have are in my rollover IRA. (You “rollover” work retirement accounts directly into an IRA account with a major brokerage firm, like Fidelity or Vanguard. Instructions for rollover are located from your employer or your new chosen brokerage. A “brokerage” is like a bank for retirement accounts, except it has a lot of choices of where to park or invest your money.)

So That’s Why an Index Fund

Costs are a reality that can eat away at your retirement savings. When given a choice, choose index funds that follow a major index. Buy it, then leave it alone. Just let it do its thing. It will go down, it will go up, and over time it will outpace inflation. It will double every 7-10 years if you leave it alone as long as returns average at least 7-10%, which is pretty easy in the stock market (Rule of 72). And for heaven’s sake, don’t buy any individual stocks. That’s too much risk. Even if you know the company and love the company and your best friend works there and has “inside” information of an upcoming acquisition, don’t do it. (Which would be illegal information to trade on, anyway.)

This post is for informational and educational purposes only. Please do not invest in anything until you understand it. Always use your mind and your judgment before selecting options, and be discerning of those who give you advice. Educate yourself. Don’t let insurance salespeople educate you. Listen to your gut. Follow the gut. Be wise.

If you’re still not confident, I recommend employing a Certified Financial Planner (CFP^®) and paying their hourly or flat rate to get your investments or other planning in order.

Happy investing!

xo, Amanda