Question mark icon with text, index funds

Passive investors like index funds for three main reasons — they’re hands-off, diversified, and affordable.

Index funds offer a plethora of other advantages too, but before you jump on the bandwagon, read on to explore the pluses, minuses, and reasons they’re so popular.

What is an index fund?

An index fund is a bundle of stocks that mirrors the performance of an index, like the S&P 500. They are passively managed, and as a result, carry lower fees than actively managed funds and usually generate higher returns.

A few well-known index funds include:

  • Fidelity ZERO Large Cap Index
  • Vanguard S&P 500 ETF
  • SPDR S&P 500 ETF Trust
  • iShares Core S&P 500 ETF
  • Schwab S&P 500 Index Fund

How do index funds work?

The beauty of an index fund is that you automatically “enroll” yourself into an investment with a diversified portfolio that has the potential to earn solid returns.

Index funds don’t aim to beat the market or try to earn higher returns than the market average. Instead, these funds try to mirror the performance of the wider securities market as a whole, which tends to go up over time naturally. (History shows that in the long-term, the S&P 500 produces an average annual return of about 10%.)

Index funds are passive investment vehicles, which means their managers don’t actively pick securities. This cuts out the middlemen — a.k.a. research analysts and others who help make sure they’re choosing the right securities for a specific fund.

Index funds don’t just track the S&P 500, which tracks the performance of the 500 largest U.S. public companies. Other benchmark indexes include:

  • Dow Jones Industrial Average, or DIJA (tracks the 30 largest U.S. firms)
  • Nasdaq Composite (tracks more than 3,000 technology-related companies)
  • Russell 2000 Index (tracks 2,000 smaller companies known as “small caps”)

Because index funds are made up of several hundreds or thousands of underlying securities, they are naturally diversified. This helps your portfolio better handle market swings because they’re less volatile than individual stocks.

As you invest in these funds, the return is paid out through dividends, which are a portion of a company’s profits. How much you receive in dividends depends on the security types of the funds you have. For example, some of them pay monthly, some quarterly, and most of them pay annually.

Are there different types of index funds?

You can invest in a wide variety of index funds. Some common types include:

Balanced index funds: Invest across asset classes and may hold a combination of stocks and bonds.

Bond index funds: Invest in corporate debt, government bonds and municipal bonds.

Dividend index funds: Focus only on indexes of stocks that pay high dividends.

Equity index funds: Track specific stock indexes, like the ones listed above.

International index funds: Track indexes in other countries.

Sector index funds: Invest in a specific sector, such as technology, consumer staples, utilities, health care, etc.

Socially responsible (SRI) index funds: Promotes causes like protecting the environment or improving workplace diversity.

Total market index funds: Aim to capture a total investable market.

Why are index funds a popular choice?

When you have so many options to tap into the market, what makes index funds stand out? The first reason is simple: They’re hands-off, and you can hold on to your investment for the long haul. Plus, you don’t have to monitor them regularly (once or twice a year should typically suffice).

While index funds aren’t immune to short-term market ups and downs, indexes in general also tend to rise over time. You may not get high returns during a bear market (when the stock market is down), but it’s unlikely you’d lose your entire investment in one day during a bear market. And as long as you hold on to your index fund investment through to the other side of a bear market, there’s a strong chance it will recover losses over a period of time.

Another benefit of index funds? They tend to have fewer fees than other actively managed funds, as the cost of commissions and management of the account, known as expense ratios, are usually lower. That means you get to hold on to more of your returns.

Finally, you get an instantly diversified portfolio when you invest in index funds because you’re putting your money into a bundle of securities — not a single stock. This is a smart way to manage risk and make your portfolio more capable of weathering volatility.

How to Invest in Index Funds in 3 Steps

Investing in index funds is simple — all it takes is three quick steps.

Step 1: Decide how much help you want.

Whether you’re a do-it-yourself investor or prefer some professional guidance, Ally Invest makes investing in index funds easy for everyone. You can choose to manage your own portfolio through a Self-Direct Trading Account for $0 with no account minimums.

Step 2: Check the fees.

While low costs are a major perk of index funds, it’s important to not assume all funds are necessarily cheap. Take time to review the administrative costs of any fund before you invest, as these costs are subtracted from your returns as a percentage of your overall investment.

You’ll want to closely review expense ratios and tax-cost ratios. It’s relatively easy to find the expense ratio in the fund’s prospectus or when you type in the ticker symbol on a financial website. In addition to paying fees, owning the fund may trigger capital gains taxes if held outside of tax-advantaged accounts like a 401(k) or an IRA. You’ll typically pay approximately 0.3% of returns when you invest in an index fund.

Step 3: Choose your index fund.

To pick an index fund, you’ll want to consider certain criteria, like which index do you want to track? Or, which type of index fund would you like to invest in? A few other aspects to think about may include company size and capitalization, geography, business sector or industry, asset type, and market opportunities. At Ally Invest, we make it easy to research funds so you can pick one that suits your portfolio, investment style, and goals.

Things to Consider When Investing in Index Funds

With all the hoopla surrounding index funds, you may fall all in for them, but no investment is perfect. Index funds, like any investment, can go through ups and downs and you may incur losses. Beyond that, it’s important to consider some other drawbacks you may face with this type of investment.

For example, you can’t react to individual stocks. So, should a particular stock become overvalued, you might think it’s a smart time to start lowering your portfolio’s exposure to that stock. However, if you invest solely through an index, you can’t do anything about that.

Similarly, you may like specific companies in an index but might not like others due to personal values or beliefs. For example, you might not like how a specific company treats the environment or that one is lacking diversity on its board of directors. But you can’t pull the companies you don’t like out of the index and keep the ones you do like.

The bottom line: An index fund may have less flexibility than a non-index fund because you can’t react to or pick the individual securities in the index.

Index funds may also not be the smartest move in a rising interest rate environment. In that situation, you might be better off investing in money market funds, short-term bonds, and any other instruments that are advantageous when rising interest rates occur.

Alternative Investment Options

You can find a plethora of investment options available to you beyond index funds. Here are some great alternatives that you can add to your portfolio.

Individual Stocks

One share of stock represents a partial stake of ownership in a company. You buy stock in companies where you expect the stock price to rise so you can eventually sell your shares and make a profit.

ETFs

An exchange traded fund (ETF) is a basket of securities that tracks an underlying index. The biggest difference between ETFs and index funds is that you can trade ETFs throughout the day like stocks, but index funds can be bought and sold only for the price set at the end of the trading day.

Mutual Funds

Traditional mutual funds allow you to pool your money together with other investors to purchase a collection of stocks, bonds or other securities. Unlike index funds, they’re actively managed.

Bonds

Governments and corporations issue bonds when they want to raise money. When you buy a bond, you give the issuer a loan and they agree to pay you back in a specific amount of time, with interest.

Note: Along with a Self-Directed Trading Account, when investing in stocks or ETFs, you also have the option of investing through an Ally Invest Managed Portfolio, which combines management by a team of investment specialists and robo-advisor technology. With a cash-enhanced Managed Portfolio, you won’t pay advisory fees or rebalancing fees, and all you need is $100 to get started.

Add indexes to your portfolio mix.

Now that you’ve finished your crash course on Index Funds 101, it’s time to apply your learnings to the real world.  If index funds feel like a fit for your investment strategy, it’s never too late — or too early — to get started.

Explore your index funds options with Ally Invest.

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Headshot of Melissa BrockMelissa Brock is the Money editor at Benzinga and founder of College Money Tips. She really enjoys helping people achieve their personal finance goals as well as money goals within the college search process.