Investing in the stock market can be a very intimidating proposition. There are over 9000 individual stocks to choose from on the major exchanges, then you have the pink sheets, exchange traded funds, sector funds, preferred stocks, foreign investments, ADRs, options – has your head stopped spinning yet?
Fortunately for the average investor, Wall Street has made life a little easier by introducing index funds.
What Are Index Funds?
Index funds were first introduced on December 31, 1975, by John Bogle. As you might know, John Bogle is the founder of the Vanguard Group – a group of mutual funds focused on good returns, with some of the lowest management fees in the industry. This first index fund is now known as the Vanguard 500 Index Fund.
Index funds are simply a collection of securities that represent the securities in a particular index. The fund accomplishes this by purchasing the same ratios of the target index, but in smaller proportions. For example, the Vanguard 500 Index Fund. This fund replicates the holdings in the S&P 500 Index.
Index funds are an easy way for investors to invest in indexes, but without having to buy each individual security in the index.
The Advantages of Index Funds
Index funds came aboard to challenge mutual funds, which for years under performed the market indexes. As mentioned, it would be impractical for an investor to buy each security in an index, so the creation of index funds were just perfect for these investors.
Low fees is first on the list of advantages. Mutual funds were popular, but management fees could easily eat into a funds gains, and this was one reason mutual funds had problems outperforming indexes. Index funds have very low fees, because they are not actively managed.
Tax efficiency is another advantage index funds have over mutual funds. Actively managed mutual funds can rack up numerous taxable transactions, where as index funds only buy and sell when the index makes adjustments. Indexes such as the S&P 500 and the Dow Jones may only make changes once every two years.
Diversification. Having a collection of 500 stocks, as in the Vanguard 500 Index, gives investors a large basket of securities across a diverse spectrum of sectors and asset classes. For those investors that want an even bigger basket of securities, there’s the Wilshire 5000 Index Fund (total market index) that has a mix of small, mid, and large cap stocks. Of course the number of stocks in the portfolio is 5000, or more.
Simplicity and low costs are what attracts most investors to index funds. You buy index funds just as you would any mutual fund. Some companies have a minimum initial investment, but do allow you to make smaller monthly purchases going forward.
We haven’t covered enhanced or specialized index funds, but as you dig deeper into the pool of index funds you will find some very interesting alternatives, which may fit quite nicely in your portfolio…welcome to the world of index funds.
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