What is a Broad Based Index Fund?

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One of the best ways of diversifying a stock portfolio is via index funds. These instruments are capable of tracking stock market sectors, market capitalizations or geographies depending on their construction. Investors have a wide range of index funds available to them, with some of the most popular being broad-based index funds. Buying a broad-based index fund can be a great way to instantly diversify a stock portfolio with little effort or cost. Here's how they work.

Understanding Broad-Based Index Funds 

An index fund is a financial instrument that tracks a group of stocks according to a preset methodology or criteria, called an index. Indices are published by a variety of organizations, with notable ones including MSCI and S&P Global. Because investors cannot invest in an index directly, they must buy an index fund, which replicates the performance and composition of a market index by buying its underlying holdings.

Index funds are passive, so the decision on whether to include a stock depends on the underlying market index's rules. For example, an index might have the rule that it only holds stocks with a market capitalization of $2 billion or below. Thus, an index fund tracking that benchmark index is restricted to stocks with a market cap of $2 billion or less.

Compare this to active funds, where the fund manager has the discretion to pick and choose stocks according to research and strategy. With active funds, the wealth manager is not restricted to selecting stocks based on an underlying index.

How Do Broad-Based Index Funds Work?

In general, stock index funds can take the following forms.

Thematic

These funds track niche or new industries such as genomics, electric vehicles, solar power, batteries, etc. Because thematic indices can be so diverse, investing in a theme is not the same as investing in a segment of the market. For example, an environmental, social and corporate governance (ESG) fund is focused on a host of companies that are ESG-centered, but they are not all in the same industry.

Sector-Specific 

These funds track one or more of the 11 Global Industry Classification Standard (GICS) stock market sectors, which include energy, materials, industrials, utilities, healthcare, financials, consumer discretionary, consumer staples, information technology, communication services and real estate.

Market-Cap-Specific

These funds track stocks based on their market capitalization (share price x outstanding shares), such as micro, small, mid, large and mega-caps.

Geography-Specific

These funds track stocks based on their location of origin, such as U.S., international developed, emerging markets, Europe, Japan, etc.

Style-Specific

These funds track stocks based on their fundamentals, usually in terms of growth versus value stocks or a blend of both.

The most popular type is the broad-based index fund. These funds are designed to mimic the performance of the overall stock market for a particular geography. For example, a U.S.-based broad-market index fund would track large, mid and small-cap stocks, with a value and growth blend, from all 11 market sectors listed on U.S. exchanges.

Most broad-based index funds are market-cap-weighted. Large-cap stocks are represented more, and sectors with a higher proportion of large-cap stocks are held in larger amounts. For example, the popular CRSP U.S. Total Market Index is 85% large-cap stocks, with a 24% weighting to technology sector stocks.

Broad-based index funds are often used as basic building blocks for an investment portfolio. By buying a broad-based index fund, investors gain access to thousands of stocks from various geographies, sectors and market caps. Professional investors often use broad-based index funds as a benchmark for their stock-picking or investing strategy's success.

Benefits of Investing in Broad Market Index Funds

Investing in a broad-based index fund has many advantages for beginner and advanced investors. Most of these benefits are behavioral, as the hands-off, passive nature of a broad-based index fund can discourage bad habits like market timing.

Broad Diversification 

By holding hundreds, if not thousands of stocks, broad-based index funds help investors mitigate the risk of a poor stock pick tanking their portfolio. Because they hold a mixture of different stock market sectors and market caps, broad-based index funds are less susceptible to stock-specific risks like bankruptcy and poor earnings reports. If a company in your broad-based index fund goes under, the effect on your overall investment will be minimized.

Low Expense Ratios

One of the easiest sources of risk to mitigate in an investment portfolio is fees. These come directly out of your returns. For example, consider two identical $10,000 portfolios each invested in the same investments. However, one charges an expense ratio of 0.05%, while the other charges 0.50%. The first one charges an annual fee of around $5, while the latter pays $50. As time goes on, these fees can compound and result in a significant opportunity cost, especially as your investment portfolio grows larger. In general, broad-based index funds are significantly cheaper than their sector-specific, thematic or active counterparts.

Peace of Mind

Investing in a broad-based index fund allows investors to obtain the average return of the overall market net of fees. For most investors, the biggest boon to long-term returns comes from good investment behaviors. This means not chasing past performance, panic-selling or market timing. With a broad-based index fund, avoiding bad behaviors is easier as investors don't have to worry about which stocks to pick, which geographies to invest in or which sectors to weigh more heavily. Investors who buy a broad-based index fund can instead focus on making consistent contributions and staying the course, which can significantly boost their long-term returns.

Considerations for Broad-Based Index Funds

When it comes to selecting the best broad-based index fund for your portfolio, the following considerations should be examined.

Underlying Index

Investors should examine and understand the underlying index that the broad-based index fund tracks. Questions to ask include: 

• Is it specific to a certain geography?
• What market caps does it include and in what proportions?
• Does it include all 11 stock market sectors, and if so, what are the weightings?
• How often is the market index reconstituted and rebalanced?

Expense Ratios

The expense ratio is the annual fee deducted from the overall amount you have invested in the broad-based index fund. For example, a hypothetical fund may charge an expense ratio of 0.03%. This means that for a $10,000 portfolio, the annual fees come out to: 0.03% * $10,000 = $3. All else being equal, the broad-based index fund with the lower expense ratio is usually a better buy.

Tracking Error

Tracking error is the percentage that the broad-based index fund's performance deviates from the returns of its underlying index. Tracking error can be positive (outperformance) but is usually negative (underperformance) because of fees, fund turnover and human error. While historical returns should not be used to predict future performance, they can be compared to the historical returns of the underlying index to examine differences. A large negative tracking error could mean inefficiencies for the index fund or poor management, which is undesirable.

Top Broad-Based Index Funds

The following broad-based index funds are popular with U.S. investors. They provide a combination of high diversification, low fees, strong volume and good assets under management (AUM). While you shouldn’t invest just because of an ETF’s AUM, you should know that a larger broad-based index fund could provide more stability in the future. At the same time, smaller funds may have more growth potential.

SPDR® S&P 500® ETF Trust (NYSEARCA: SPY)

SPY is the largest and most liquid exchange-traded fund (ETF) in the world. It tracks the S&P 500 index, a market-capitalization weighted portfolio of 500 large-cap U.S. equities. The index is often used as a barometer of U.S. stock market performance and a benchmark for investors to compete against. With $357 billion in AUM and a minuscule bid-ask spread, SPY is an excellent broad-market index fund for investors and traders. It also features a well-developed options chain with a wide selection of strike prices and expiry dates. In terms of fees, the ETF costs an expense ratio of 0.0945%. SPY has returned an annualized 12.93% over the trailing 10 years.

Invesco QQQ Trust Series 1 (NASDAQ: QQQ)

QQQ tracks the Nasdaq-100 market index, a market-capitalization weighted portfolio of the 100 largest non-financial companies trading on the Nasdaq exchange. Although not as diversified as the S&P 500, the index is still referred to as a barometer for U.S. mega-cap stock performance. Compared to SPY, most of QQQ (50%) is held in the technology sector because of the high number of technology companies listed on the Nasdaq. Over the trailing 10 years, QQQ has returned an annualized 17.33% thanks to the outperformance of FANG tech stocks. The ETF costs an expense ratio of 0.20%. Like SPY, QQQ also has a strong daily volume, high AUM ($161 billion) and a well-developed options chain.

Vanguard Total International Stock Index Fund (NYSEARCA: VXUS)

U.S. stocks comprise 60% of the world's total market by market capitalization weighting. For maximum diversification, investing in international index ETFs from developed (Canada, Europe, Japan, Australia, U.K.) and emerging (Russia, China, Africa, South America) markets might be a good idea. This practice can hedge against the possibility of the U.S. stock market stagnating for a prolonged period, like during the "lost decade" of 2000 to 2009. VXUS tracks the FTSE Global All Cap ex US Index and holds 7,819 international stocks for a low expense ratio of just 0.07%.

Maximize Diversification with Minimal Effort

Broad-based index funds are one of the best ways to diversify a stock portfolio with little effort or cost. Investors have a range of index funds available to them, including ones such as SPDR S&P 500 ETF Trust, Invesco QQQ Trust Series 1 and Vanguard Total International Stock Index Fund. These funds are capable of tracking different market sectors, market capitalizations or geographies depending on their construction. They are also passive investments that track a group of stocks according to a preset methodology. A larger broad-based index fund could provide more stability in your future, which is useful for any investor that wants exposure with low risk and minimal effort. These index funds have low fees and strong volume, and they are provided by various investment companies. Investors should note that investing in broad-based index funds could have capital gains if you make a nice profit, so it is always prudent to consult a tax professional.

Compare Index Funds Brokers

Investors looking for further insights and reviews of broad-based index funds can use Benzinga to compare the available brokerage account options. Here is a list of brokers that support index funds.

Frequently Asked Questions