If you’ve been exposed to the world of investing, then you’ve probably heard of the term “index fund” before. This is a very common thing in the investing space, serving as an alternative to placing capital just into single assets. If you’re into passive investing or are seeking to diversify your portfolio, index funds might just be the way to go especially if you are still a beginner when it comes to investing. Even investing mogul Warren Buffett has personally endorsed the use of index funds as a means of building wealth over a longer period of time. So let’s go over what an index fund is and why they might be the right investment option for you.

This is not financial investment advice.

This article touch upon key aspects of index funds.

In this article

What’s An Index Fund

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index. When you invest money into an index fund, you’re gaining exposure to a wide variety of assets that operate under a single market. Instead of just investing in a single asset, index funds provide broad market exposure, low operating expenses, and low portfolio turnover rates. These funds adhere to specific rules or standards that stay consistent irrespective of how the markets are doing.

GIven that an index is composed of stocks or bonds that satisfy a number of required characteristics, the decision-making process is actually outsourced to the people in charge of developing the index. This can save investors a lot of money because there’s no need to pay a mutual fund manager to make those decisions. Even so, index funds still have a portfolio manager who works to get results as close to the index as possible. The best way to do that is to buy and sell assets as they join or leave the index list. The hardest part is doing so in a way that minimizes taxable capital gains, which are the gains made from buying and selling a stock position.

An index is a list of stocks or bonds that is assembled based on some set of rules. For example, the Standard & Poor’s 500 (S&P 500) is a list of the top 500 stocks traded on the New York Stock Exchange and Nasdaq by market capitalization. This is a form of passive investing and provides exposure to a broad variety of assets within a market.

Different Types of Funds

There are several different kinds of index funds available to invest in, and while there are a few index funds available for the cryptocurrency market, they are only available to accredited investors who satisfy any of the requirements regarding net worth or income set forth by the SEC. The first type of index fund is known as a broad market index fund. These invest in an index designed to track the performance of the entire market, or a subset of the market such as large-cap stocks. Some examples of these kinds of index funds include The Dow Jones Industrial Average, S&P 500, and Russell 2000 indices.

Next, we have global/International index funds. These are designed to provide exposure to stocks from all over the world. Global indices include stocks from across the world, while international indices exclude U.S.-based companies. And finally, we have the sector-specific index funds, which are designed to track a sector’s performance. For example, the Financial Select Sector SPDR ETF (NYSEMKT: XLF) is designed to mirror the performance of the banking, insurance, and real-estate industries. There are sector-specific indexes for all kinds of markets, even including cryptocurrency!

Outside of these index funds, there is also a type of fund known as a “leveraged ETF,” which is worth mentioning in the context of index funds. These funds often track an index, but aren’t the same type of investment as an index fund. Otherwise known as ETFs, these investment options differ significantly from that of index funds and should not be mistakenly used interchangeably. It’s important to be aware of what makes an index fund so unique, so be sure to understand that they fall into a completely different category than ETFs, which are actually subsets of index funds.

There are several different kinds of index funds that are available to invest in, and while a cryptocurrency index fund does exist, it’s only available to accredited investors. It’s important to understand that index funds are different from ETFs, which are subsets of index funds.

Pros & Cons

When it all comes down to what kind of investment you want to make, there are several reasons why one should and shouldn’t consider index funds. Of course, it all depends on your situation and what kind of investing experience you’ve accumulated, so take all these advantages and disadvantages with a little grain of salt.

First and foremost, as long as the investor realizes that there are good indices, bad indices, and mediocre indices, he or she should be able to participate in whatever underlying market it represents with a single purchase. That has a lot of convenience and can mean lower transaction costs, which matters if you’re only investing a small amount. Remember, high commissions could eat up a meaningful amount of your returns if you attempted to build your own stock portfolio directly in a brokerage account.

Also, many index funds tend to be run in a way that minimizes turnover, which has long been a key to successful investing. If your index manages to maintain its low turnover ratio, then you will have the best chance to increase your gains over a longer time period than say, building your own portfolio filled with many individual assets. On top of that, index funds by nature are already diversified, which diffuses any fear that the fund will crash in the event of a single asset tanking. One of the most important pieces of advice when it comes to investing is to keep your portfolio diversified, which isn’t a problem with index funds.

However, there are also some reasons why one might not want to consider index funds when investing. One of the biggest limitations is that you’re essentially relinquishing control over your holdings. Your investments in an index fund are made at the whims of the index rule makers. This means that even if you dislike a company and don’t want to own its stock, you’ll have to if it’s part of the index you otherwise like. Correspondingly, if you want to own an asset that isn’t in the fund, you’ll have to invest in it yourself which runs the risk of incurring high commissions.

Investing in index funds also removes your ability to react to the market, which may or may not be a bad thing. Depending on whether or not you fall into FOMO quickly, this passive form of investing removes your ability to actively react to any market movements. For someone who is not comfortable taking a hands-off approach to investing, index funds may not be the way to go.

Index funds have several advantages including low turnover ratios, passive forms of investing, and diversified portfolios. On the other hand, they also run the risk of taking a back seat to your own portfolio and removing the ability to actively react to market conditions.

Conclusion

For the Average Joe investor, index funds may not mean much when it comes to actual investment opportunities. For crypto users, index funds might not mean anything since there haven’t been too many that’ve been made available, and those that are available are only for accredited investors. However, regardless of whether or not you may want to invest in index funds, having the basic understanding and knowledge of these concepts will further grow your financial literacy. Any investor who aims to succeed in his or her own personal endeavors should most definitely familiarize themselves with these key terms, one being the traditional index funds. As the cryptocurrency industry continues to grow, look out for any new index funds which may be made publicly available for all investors to place capital in.