What Are Index Funds?

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Narrator: Funds that track a market index, such as the S&P 500^®, are known as index funds.

Index funds include both index mutual funds and index exchange-traded funds, or ETFs. These funds typically use a passive investing strategy, which means their objective is to deliver returns similar to an index of investments. However, index funds usually deliver returns that are slightly lower than an index due to fees associated with these funds.

In this video, we'll discuss how index funds work, identify some of the indexes these funds track, and examine benefits and risks associated with this type of fund.

Simply put, index funds are built to have a similar performance to that of a major market index. This means they tend to be diversified in securities across that index and include a number of investments.

There are many market indexes, and index funds that follow them.

For example, if you want to invest in U.S. stocks, you might invest in a fund that tracks an index like the S&P 500, which follows the 500 largest stocks in the market; the Dow Jones Industrial Average^®, which includes 30 large-cap industrial stocks; the Nasdaq-100^®, which follows 100 large-cap technology stocks; or the Russell 2000^®, which tracks 2,000 small-cap stocks.

For international stocks, an example of a widely tracked index is the MSCI EAFE, which includes large-cap stocks in developed countries across Europe, Australia, and the Far East.

On-screen text: Investments in bonds and fixed income products are subject to various risks and special tax liabilities. You should discuss any/all implications of investing in such products with your broker and/or tax advisor.

Narrator: For U.S. bonds, an example of a widely tracked index is the Barclays Capital Aggregate Bond Index, which includes a mix of government bonds, mortgage-backed securities, and corporate bonds with different maturities.

As you can see in these examples, index funds can track different assets, including stocks and bonds. There are even index funds that follow commodities, currencies, and other assets.

But regardless of which type of asset they track, an index fund still has its risks.

Put simply, index funds are exposed to the same risks as the index they're following.

For instance, if the S&P 500 declines in value, then the index funds which track it will follow suit.

An index fund that tracks bonds is at risk if interest rates rise and bonds decline in value.

Some investors are willing to accept these risks and choose to invest in index funds because of the potential benefits they might offer.

A primary benefit is the typically lower expense ratio—which is the ongoing cost of investing in the fund—compared to actively managed funds.

As the name implies, actively managed funds use an active investing strategy. This means that they frequently buy and sell investments. This typically results in higher costs, or expense ratios, and can be a drag on a portfolio's performance over time.

Because index funds are passively managed and simply track an index, they generally have a low portfolio turnover, which means they infrequently buy and sell investments.

Infrequent buying and selling typically translates into low expense ratios.

The low expense ratios of index funds can possibly lead to more growth when compared to the higher expense ratios of similar actively managed funds. Let's look at an example.

On-screen text: For illustrative purposes only. Not a recommendation of any security or strategy. Not indicative of an investment in a particular investment. Past performance is no guarantee of future results.

Narrator: Suppose an investor purchases $50,000 of two funds that both grow 7% per year—before expenses—over the next 30 years. The funds are similar in all respects except the expense ratio.

Fund A is an actively managed fund with an expense ratio of 1.2%. This fund would grow to $271,356.

Fund B is an index fund with an expense ratio of 0.2%. This fund would grow to $359,838.

That's a difference of $88,482, and it's all thanks to a low expense ratio.

The low cost of passively managed index funds can make a difference and is a reason index funds may outperform actively managed funds over long time periods.

This is why some investors take the "if you can't beat 'em, join 'em" approach and use index funds to simply track market indexes.

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