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Index Funds Explained (So You Actually Understand Them)

Patrick Chism3-minute read
March 21, 2022

Index funds have surpassed traditional mutual funds as the popular investment for wealth building. It’s understandable: the fees are lower, and the returns have proven profitable for many. Created in 1975 by Jack Bogle, the idea was to give the individual investor an opportunity to invest like the professionals – without the costs of actively managed funds.

How Does An Index Fund Work?

An index fund tracks the performance of a market index. It does have a fund manager, but their job is to monitor the index being tracked and buy or sell when the index makes changes to its portfolio. This makes sure the index fund continues to “match” the index itself. This is considered passive management because there is no research involved and equates to lower fees for the investor, unlike mutual funds.

When an investor purchases shares of an index fund, they aren’t purchasing the entire index – that would be expensive. They are purchasing a percentage of all the stocks in that index.

There are a lot of stock market indexes in the U.S. and internationally. The most popular U.S. stock market indexes are listed below, and there are many index funds for all of them:

  1. S&P 500 – Based on the market capitalization of 500 of the larger U.S. companies, many consider it the best representative. Market capitalization is the value of the outstanding shares of a company.
  2. Nasdaq – another index focused on market capitalization representing the stocks of 3,000 U.S. companies – mostly technology companies.
  3. DJIA – composed of the price weighted average of the 30 significant stocks that are traded on the NYSE and Nasdaq. Price weighted simply means stocks with higher prices are given greater weights.

There are two types of index funds:

  • Index Mutual Fund – purchased through mutual funds
  • Index Exchange-Traded Fund – traded directly on stock exchanges

When you see Index Fund vs. ETF, this is the comparison that is being made. This can be confusing because an ETF is a type of index fund, so just keep this in mind.

How Do You Analyze Index Funds?

Once you determine which brokerage and funds you’re considering, you’ll want to review the likelihood of its financial growth. Each index fund has a ticker symbol you can use to analyze its returns just like any stock or mutual fund. You enter the ticker into an investment analysis website search like Morningstar or Yahoo Finance and you’ll find information regarding the financial strength of the fund. Here are some things to research as well: 

  1. The fund’s performance over the past 5 – 10 years. What is the year-over-year percentage return? Look for a history of continuous increases – if there was there a dip, can it be explained?
  2. The annual report for the fund. It may not be the snoozer you would expect, and it will give you insight into the future of the fund.

News articles you can find regarding the fund and the company that owns it. Has there been negative press? What do current investors say about their returns or management of the fund?

How Do Index Funds Make Money?

Index funds make money by earning a return. They’re designed to match the returns of their underlying stock market index, which is diversified enough to avoid major losses and perform well. They are known for outperforming mutual funds, especially once the low fees are taken into consideration.

How To Invest In Index Funds

Investing in index funds is simple – you can access them directly through the online brokerage website of the fund you choose, or you can purchase with your investment broker. In our digital world, it’s easy to create an account online and purchase your index fund. The websites walk you through each step and explain their investment products thoroughly.

The process is the same as any other investment:

  1. Look at your disposable income – the money left after you pay your bills, save and give. How much can you afford to invest?
  2. You want to first make sure you’re educated and fully understand what index funds are and how they work.
  3. Choose an online brokerage firm or use your current broker if you have one.
  4. Find out what their investment minimums are, and what amount you have to have in order to invest.
  5. Look for the fees are associated with the account. Check the “expense ratio” – the average for index funds is .2%, though many now have 0% expense ratios.

How do you like index funds? Have you found them more beneficial than other investments?

Patrick Chism

Born and raised on a farm in the Ozarks, Patrick has a knack for making the best out of the worst situations. Where others see flooded farmland, he sees lakefront real estate. Where others see an infestation of bees, he sees free pollination and a upstart honey shop. Patrick’s articles will help you make the most out of the least, maximizing your returns while keeping a close eye on the wallet. When he’s not writing for Rocket Mortgage Patrick likes hiking, gardening, reading and making healthy foods taste like unhealthy foods.