Last week, I defined mutual funds and exchange traded funds (ETFs). Mutual funds are funds with a bunch of different securities in them, are actively managed, and are valued after close-of-business. ETFs also have a variety of securities, are passively managed (by tracking an index), and are bought and sold just like a stock throughout the day. In the middle of those two types of investments are index funds. I promised you I’d explain a little bit more about them today. So without further adieu…
Market Indices
An index fund is a type of mutual fund that is designed to match – you guessed it – an index. WTF is an index? Good question.
The technical definition per Investopedia is that a market index is “an aggregate value produced by combining several stocks or other investment vehicles together and expressing their total values against a base value from a specific date.”
Yeah. I’m an Investopedia fan, but what does that mean???
Here’s another try: a market index tells you the collective value of a certain group of stocks. The groupings can be, well, anything I suppose. I could be wrong about that, but I’ve never seen any rules on it. But some of the common groupings you hear about All.The.Time. are the S&P 500 (S&P stands for Standard & Poors), the Dow Jones Industrial Average, and the Nasdaq Composite.
The S&P 500 is an index that tracks 500 of the most widely traded companies in America. It’s a pretty broad index and it is a fairly good indicator of the market as a whole. If the market is doing well, the S&P 500 is probably doing well, and vice versa.
The Dow Jones Industrial Average (DJIA) is….not that good, in my non-expert opinion. That’s because the DJIA is made up of only 30 stocks. They are 30 of the biggest, most influential companies in America, but since there are only 30 of them in the index, the DJIA isn’t as good of an indicator of the market as the S&P 500. This is especially true because the DJIA favors really large companies, and may not correspond to the market as a whole. It’s not necessarily a bad index, just keep its size in mind when you are talking about “the market” and DJIA.
The Nasdaq Composite is comprised of all of the stocks in the Nasdaq stock exchange. In addition to US companies, it includes some international players too. Plus, it includes some smaller companies and a lot of tech companies.
Those are just a few of the indices you may hear about. There are plenty more, which allows for diversification of your diversified index funds! We do love diversification here at Military Dollar.
Index Funds
Now that you know what an index is, it’s probably pretty easy to understand what an index fund is.
An index fund is a mutual fund that tracks an index. Given what I said above, that means there are index funds that track the S&P 500, DJIA, and Nasdaq Composite indices. Plus other indices that I haven’t mentioned. Lots to choose from!
Here’s why I love index funds, and you should too. Remember when I talked about how mutual funds are typically actively managed, and that you pay an expense ratio that includes the cost of that management? Well with an index fund, the fund tracks an index as closely as possible. That means you don’t need a manager deciding what to invest in. The index is what you invest in. The fund simply follows the index. It’s passive investing. This means….drumroll…you aren’t paying for active management. The benefit is that index fund expense ratios are low, on average, compared to most mutual funds.
How low? A mutual fund will usually have an expense ratio (FEES!) of .5% to 1%, although it’s not uncommon for them to be 1.5% or possibly higher. An index fund is more like .25% – or significantly less! As I mentioned last week, that means that a mutual fund with a higher expense ratio has to perform better than an index fund with a lower expense ratio just to equal out.
Long story very short: all else being equal, lower expense ratios are better.
Plus…managers aren’t very good at picking stocks that beat the indices.
Should You Invest In Index Funds?
Let’s start off with my caveat: I am not a personal finance professional, I am not providing financial or investing advice, and you should talk to a personal finance professional before making any changes to your investments if you have any questions. You are 100% responsible for your investments and decisions. As always, you can read my full disclaimer here. Cool? Cool.
Yes, you should invest in index funds.
Here’s the deal. Humans are really bad at predicting the future. They are even worse at predicting the future of the stock market.
The best market predictor around, Warren Buffett, recommends you buy index funds. Why? Because he knows you aren’t going to reliably find a better fund out there. He has bazillions of dollars, and his will says that when he passes 10% of the money he is leaving to his wife should go into bonds, and 90% into an S&P 500 index fund. Seriously. Check it out (page 19, right above the asterisks).
In fact, Warren Buffett thinks index funds (passive investing) are so much better than active, managed investments that he made a $1 million bet on it almost 10 years ago. The bet? That an index fund would beat an actively managed fund over a ten year period.
Now, obviously you can invest any way you want. Me? I’m going to follow the advice of Mr. Buffett. I’ll stick with my index funds and do some long-term buy and hold investing.
ETFs vs Index Funds
One last thing before I go. Last week, I promised to discuss the differences between ETFs and index funds. I said that one had simplicity and the other had flexibility, right?
Here’s the deal. An index fund, like a mutual fund (because it’s a subset of mutual funds) can be purchased without a brokerage account. You can just go to your bank and buy one. Plus, they are the epitome of a buy and hold investment. You buy the index, and then the rest of the work is done for you. Easy peasy.
An ETF, on the other hand, can be traded like a stock. It benefits from a lot of flexibility, because you can buy and sell any time the markets are trading. If you are a trader, that’s a huge plus. And, because of the in-kind redemptions I mentioned, ETFs can be better tax-wise if you plan to buy and sell.
ETFs can be as simple as index funds, since they are a type of index fund. But the way they are set up legally means they are a little more beneficial for people who like to trade rather than buy and hold investors.
Which one is better? It really depends on you. There is more to it than I’ve included here, of course. If I got into all of the differences between index funds and ETFs, this post would quickly balloon to 3,000+ words. But if you want the truly quick-and-dirty version, index funds are a little better if you like to be truly passive. ETFs are a little better if you want to move your money around more.
I’m going to get into more nitty gritty details about the differences between these investments in later posts, so sit tight. I promise there’s more learnin’ comin’. But I think that’s enough for a Friday. Time to go enjoy a donut.
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