A Beginner's Guide to Index Investing

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Main takeaways

• Index investing focuses on tracking the market rather than trying to beat it, usually through index funds or ETFs.

• Passive funds often outperform active ones because they carry much lower fees and most stock-pickers fail to consistently beat the market.

• Investors benefit from diversification and tax efficiency, since index funds spread risk across many companies and generate fewer taxable capital gains.

• Drawbacks include lack of control and sector risks, making them less appealing for socially responsible investors or those seeking active management in volatile international markets.

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Not long ago, mutual fund investors thought the best way to find strong returns was by latching onto brilliant fund managers with a knack for finding the next big company. Over the past couple decades, however, investors warmed to a completely different strategy: buying the market instead of betting on individual stocks. 

Though index investing isn’t without its pitfalls, the reasons for its steady ascent are hard to deny. Here’s a quick look at what this strategy entails and why index funds continue to be a great choice for many investors. 

What is index investing? 

A traditional mutual fund is run by a manager or team of managers who select the stocks or bonds that the fund owns. Based on input from their investment analysts, fund managers may decide to buy shares of a company that they believe is poised for bigger things. Or they may offload a stock that suddenly looks overpriced. 

In the 1970s, John Bogle of Vanguard pioneered a completely new approach: a fund that bought weighted shares of each and every company in a certain index. An index fund tracking the S&P 500, for instance, contains shares of each of the 500 largest publicly traded companies in the United States. And an index fund tied to the Russell 2000 Index represents 2,000 smaller (though definitely not tiny) companies whose shares are traded on the various exchanges. 

The vast majority of index funds don’t own equal amounts of the shares they buy. Rather, they buy a “weighted” amount of shares, purchasing larger stakes of companies that have a bigger market capitalization. 

Index funds aren’t the only offerings that use a “passive” investment strategy. Many exchange-traded funds—baskets of securities that trade like stocks—also mirror one index or another. These days, the likes of Schwab, Fidelity, Vanguard and BlackRock (iShares) all offer “index ETFs” for customers who prefer them to traditional index funds. 

Why passive investing has gained steam

Importantly, index funds aren’t trying to beat the performance of the market as a whole; rather, they’re trying as best possible to mimic the returns of whichever stock or bond market they replicate. 

If that sounds like a boring strategy, it is. But the fact is, most professional stock-pickers haven’t been very good at delivering results for investors. For example, since 2000, the majority of actively managed large-cap funds have only managed to beat the S&P 500 three times, according to S&P Dow Jones. Yet they tend to impose significantly higher annual fees on their investors than their indexed counterparts. 

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TERMS TO KNOW 

Market capitalization

The total value of all the shares issued of a publicly traded company. Market capitalization equals the number of shares outstanding, multiplied by the price of each share.

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Pros of passively managed funds

There are several reasons why index funds and index ETFs continue to grab a bigger slice of the mutual fund market. Among them:

1. Lower fees. The average annual expense ratio for an actively managed fund is around 0.6 percent. But for stock-focused index funds, it’s a minuscule 0.05 percent. 

   
   

Of course, higher costs are worth it if a fund manager consistently beats the market by a fairly wide margin. But in most years, only a small percentage actually do.

2. Fewer taxes. Because there aren’t fund managers trying to pick winners and losers, there’s less stock trading that goes on inside an index fund or ETF. That means they produce fewer capital gains that you, the investor, has to pay a tax on. 

Short-term capital gains, generated when a share is owned less than a year, are taxed at a higher rate. The passive trading posture of Index funds results in fewer of these gains have to be reported on your tax return.

3. Greater diversification. By definition, stock index funds own shares of dozens, if not hundreds, companies. That gives you exposure to a huge segment of the market. When one company or sector of the economy underperforms, the fund’s other holdings help minimize the effect.

   
   

While passively managed funds tend to have greater diversification than their actively managed peers, however, it’s still important to diversify among different funds. For example, you may want to balance a large-cap index fund with one focusing on smaller companies, or those from emerging markets. 

Cons of passively managed funds

That’s not to say that index-based funds don’t have certain drawbacks. For example:

1. You don’t control what you own. If socially responsible investing involves getting behind only companies that you believe in, index investing is the opposite. You’re buying a large group of stocks or bonds, irrespective of whether those businesses align with your ethical priorities.

2. Liquidity may be an issue. Index ETFs have become so popular that they’re traded much more frequently than some of the individual stocks that they own. In most market conditions, that’s not a big worry for investors. But there’s a hypothetical scenario where a sudden market downturn makes it difficult for funds to liquidate their shares or sell holdings at an unfavorable price.

   
   

3. Some sectors may be too risky for indexing. Even investors who are generally favorable toward domestic index funds sometimes find comfort in using actively managed funds for their international holdings.

   
   

Emerging markets like Latin America and the Pacific Rim present greater risks of political or economic turmoil than the U.S. market. Theoretically, fund managers are able to respond when those market-altering events occur. It’s worth noting, however, that even international index funds have consistently beat their actively managed competitors over the past two decades.

The upshot

Buying a whole segment of the market with an index fund or index ETF may not be the most exciting way to invest your money. But the track record of these lower-cost funds is hard to argue against. However, those looking for a bit more control of the stocks or bonds they own may prefer socially responsible funds or securities that they personally select.