If you have a retirement account such as a 401K or IRA, you’re probably already at least somewhat familiar with mutual funds. These investment vehicles are managed products that invest in a diverse array of assets giving you built-in diversification and risk mitigation. Mutual funds are also popular for investors who have a brokerage account or use the services of a personal financial advisor.
While mutual funds vary with different investment objectives and holdings, another type of fund that often gets overlooked is the index fund. Unlike its managed cousins, index funds are passively managed and are subject to much higher degrees of volatility. The lack of downside management can lead many investors to steer clear of these products, but index funds are by and large the most misunderstood investment vehicles on the market.
Who Index Funds Are Designed For
A mutual fund usually has a benchmark index that it seeks to mimic or outperform. A management team makes changes throughout the year varying asset class weightings and buying or selling individual securities to meet this goal. Index funds, however, only seek to mimic the index that it’s associated with.
One of the most popular index funds, the Vanguard 500 Index fund, is tied to the S&P 500 (as the name implies). While minimal changes are made as stocks are added or removed from the S&P 500 index, the index fund primarily seeks to mimic the performance of the S&P 500. As the broader averages rise and fall, the index fund will similarly perform. For an ETF that seeks to mimic this index, look no further than SPY or VOO.
This can lead to much higher volatility than other managed mutual funds but has a place in the right portfolio. Conservative investors who eschew risk, or are close to retirement, shouldn’t invest in an index fund—but less risk-adverse or young investors, who are still a decade or more away from retirement, might consider investing.
By mimicking an index such as the S&P 500, these funds offer investors one of the purest plays on the stock market. Since they are passively managed, index funds have very minimal expense ratios—often times under 0.10%. That makes them ideal for long-term growth strategies.
While the stock market as a whole can be volatile in the short term with significant changes on a daily, weekly, monthly and yearly basis, the overall direction of the market is positive. Looking back 30 years, the S&P 500 has gone up nearly 1,000%—that’s an average annual return of around 8.3%. Compared to the performance of mutual funds, an index fund is a hard bargain to beat considering that most mutual funds underperform this figure without considering the extra cost of an expense ratio factored in on top of it.
Index funds are a great way to deliver solid returns over a long period of time. While investors need to watch for periods of high volatility, keeping focused on the big picture can make these funds superior to their managed mutual fund counterparts. Using index funds in combination with more conservative funds that invest in assets, such as bonds, can also be a good way to diversify your portfolio while still focusing on long-term growth.