What are index mutual funds? Your questions answered
- April 10, 2023
- 5 min read
What we'll cover
What index mutual funds are
Answers to FAQs about index mutual funds
Pros and cons of investing in mutual funds
Even if you’re new to investing, you’ve probably heard of mutual funds as an opportunity to diversify your portfolio. But what about the different kinds of mutual funds? Depending on your risk tolerance and financial goals, some types may be the perfect fit while others might be outside of your comfort zone.
By better understanding what each can and can’t do, you’ll have the tools you need to build your ideal portfolio. In this post, we’ll answer some common questions about index mutual funds , typically a passively managed fund that aims to mimic the performance of an entire market index (like the Nasdaq 100 or the S&P 500) by being composed of most or all of the stocks that make up the index.
How does an index mutual fund work?
Before we dive into how these funds work, let’s first take a closer look at what they are. As we mentioned above, an index mutual fund is typically made up of most or all of the stocks in a particular index, such as the Dow Jones Industrial Average or any of the other broad market indices covering different types of companies, industries or sectors.
The index on which the mutual fund is based is known as the target index and the mutual fund looks to track its performance. That means if the index goes up or down, the value of the index mutual fund is likely to perform similarly on a percentage basis.
The volume and variety of securities in each of these indices mean index mutual funds add instant diversity to any portfolio. They also tend to be less volatile than individual stocks. By their very nature, because index funds seek returns that match an index, they can produce fairly predictable results over time.
What’s the difference between passive investing and actively managed funds?
If you invest in an actively managed mutual fund, the fund manager has one goal: to beat the market and deliver above-average returns to fund investors (aka you). To achieve this, they’re often buying and selling the stocks that make up the mutual fund.
However, index mutual funds, as we’ve mentioned, are typically passively managed funds. This means they have different investment styles. Their goal is to meet the market by matching the performance of a specific benchmark. So, the securities making up the mutual fund remain fairly constant and only change when the makeup of the index changes. While that doesn’t quite mean you can set it and forget it, they can be a less time-consuming portion of your portfolio than an actively managed mutual fund.
When should you invest in index mutual funds?
The usual motivation for investing in an index mutual fund is to hopefully take advantage of broad-based bullish activity across stocks in the fund’s portfolio. Certainly, stocks within the index fund may exhibit bearish tendencies at any given time, but you want the overall basket of stocks to demonstrate upward momentum over time.
You may be bullish on a particular sector measured by a specific index, or on the broader markets overall. So be certain to choose the right index mutual fund to best match your sentiment. Regardless of intention, the market can always behave counter to your analysis.
Do index mutual funds have fees?
Yes, like other mutual funds, index mutual funds have fees. However, because they’re passively managed, the expense ratio (ongoing fees associated with owning mutual funds) tends to be lower. Not having to pay for a fund manager’s time and fewer transaction costs keep those expenses lower.
What are the top pros and cons of index mutual funds?
Just like any other investment, index mutual funds have benefits and potential risks. Weighing both against your own financial goals can help you make the right choice for your portfolio.
Index mutual fund pros
Because index mutual funds are composed of many different securities, your investment, in essence, is instantly diversified.
Relatively reliable returns
Index mutual funds typically track the returns of market indexes, which often means more reliable returns on your investment over time. Keep in mind, though, this kind of investment also introduces a level of risk (more on that in the cons section).
Potentially lower fees
Because index mutual funds are typically not actively managed, ongoing fees tend to be lower.
Index mutual fund cons
Index mutual funds can quickly diversify your portfolio, but that doesn’t necessarily make them a safe bet. You always assume some risk when investing in the stock market. Index mutual funds move with the market, which means if the stock market goes down, your fund goes down.
Because index mutual funds are typically passively managed and track a specific index, you have no control over the holdings. That might be a positive if you prefer a hands-off approach, but it does give you fewer opportunities to customize your investment.
Find the right index mix for your portfolio
The life of an investor is full of decisions: Where do you put your money? How long do you keep it there? The most difficult part is that there is no right (or wrong) answer. The good news is, you’re in control. Get smart about the markets and decide what will best serve your own financial goals. If a diverse portfolio that requires no active management checks those boxes for you, consider adding index mutual funds to your financial mix.
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