What is an Index Fund?

Quick Answer: An index fund is an investment fund that tracks the performance of an underlying benchmark index, such as the Standard & Poor's 500 Index (S&P 500) or the Nasdaq 100.

The purpose of an index fund is to match the performance of the underlying index. And as such, they can be a good investment vehicle for investors seeking long-term investment portfolios. Index funds can also be ideal for IRA and 401(k) accounts.

By mirroring the same holdings as its benchmark index, index funds are broadly diversified and thus hold a lower risk than individual stock holdings. Besides diversification and lowered risk compared to individual stocks, index funds are also low cost, thanks to their low expense ratio. Some charge no expense ratios. Index funds offer a straightforward and hands-off approach to investment. You log into your brokerage account, deposit capital, select your fund and hit the buy order.

Index funds offer one of the safest and easiest ways of investing for both professional investors and newbies. You could quickly build a diversified portfolio earning solid returns by leveraging index funds.

Benzinga takes a deep dive into index funds, how they work and some of the best index funds you can consider for diversifying your portfolio today. As you add these items into your portfolio, remember that they need to match your investment objectives and not simply be a good idea.

How Does an Index Fund Work?

An index fund is a special investment vehicle that allows investors to invest in a specific basket or index of securities such as stocks and bonds. It is designed to match the performance of a financial market index such as the S&P 500 or the Nasdaq 100. A market index is a hypothetical portfolio of securities representing a market segment.

When you invest in an index fund, you're investing in all the companies that make up the particular market index. This type of investment gives you a more diverse portfolio and spreads your investment risk across the stocks or bonds of many different companies than if you were buying individual stocks.

Index funds allow you to lock in the overall stock market returns or a specific segment. Index funds can be exceptional investments because they offer ownership of a diverse range of stocks, greater diversification and lower risk – typically at a low cost.

Many investors prefer index funds over individual stocks as investment options.

Examples of Index Funds

The best index funds can help grow your wealth by diversifying your portfolio while minimizing risks and fees. Here is a look at some of the index funds for your portfolio.

• SPDR S&P 500 ETF Trust (NYSEARCA: SPY)
• Invesco QQQ Trust ETF (NASDAQ: QQQ)
• Vanguard Growth ETF (NYSEARCA: VUG)

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

The SPDR S&P 500 ETF Trust (NYSEARCA: SPY) is popular on Wall Street as the grandad of exchange-traded funds (ETFs). Founded in 1993, when investing in ETFs was not as widespread as it is now, the fund was one of the significant pioneers of mainstream ETF investment. It was the first ETF listed in the U.S. The fund is sponsored by State Street Global Advisors, another heavyweight in the industry. It seeks to provide investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

The fund's stock composition spans ETFs from 500+ issuers across 24 industry groups. With assets under management (AUM) of over $330 billion and more than 50 million in daily trade volume, this fund is one of the most-loved ETFs among institutional and retail traders.

Over the last five years, the fund has returned approximately 51% ROI for investors, closely similar to S&P 500's 52% price gain. As of May 2023, the SPY is sitting only up 0.61% for the year-to-date, closely tracking S&P's similar price. It has an expense ratio of 0.0945%, putting the investment cost of $10,000 capital at $9.45 per year. As a result, it may not suit long-term hold investors, but it is still cheap compared to most actively managed funds.

This fund can be ideal for investors looking to expand their portfolio depth with a broadly diversified low-cost ETF. Thanks to its small bid-ask spread and extensive option chains, it can also serve as a great trade instrument.

Invesco QQQ Trust ETF (NASDAQ: QQQ)

The Invesco QQQ Trust ETF (NASDAQ: QQQ) is an ETF that tracks the performance of the largest non-financial companies in the Nasdaq-100 Index. It emerged in 1999 amid the ETF trading boom of the 90s and has since proven its worth. It is managed by Wall Street fund giant Invesco and, according to Lipper, was the top-performing large-cap fund in terms of total return over the 15-year timeframe to September 2021.

The fund exposes companies at the cutting edge of transformative, long-term themes such as augmented reality (AR), cloud computing, big data, mobile payments, streaming services and electric vehicles (EVs). The top five holdings of the fund are Apple Inc. (14.18%), Microsoft Corp. (10.25%), Amazon.com Inc. (6.78%), Tesla Inc. (5.11%) and Alphabet Inc. (3.51%).

Its relatively high expense ratio of 0.20% (a capital investment of $10,000 will cost $20 per year) is partly compensated by no investment minimum. So you can start investing with as little as $1. It is an excellent place to start for investors looking for an index fund that gives them exposure to the tech industry and growth-oriented companies.

Vanguard Growth ETF (NYSEARCA: VUG)

The Vanguard Growth ETF (NYSEARCA: VUG) is an excellent option for risk-averse investors who don't mind taking on more investment risk in exchange for higher returns. Launched in 2004, the fund is a large growth index fund that seeks to track the performance of the CRSP US Large Cap Growth Index. The fund primarily invests in domestic stock or general asset classes containing roughly 259 large-cap growth stocks.

Its relatively small expense ratio of 0.04% puts the investment costs for a $10,000 investment capital at $4. However, you need an account minimum of $219.08 to invest in this fund. Shares from the tech sector account for most of this fund's holdings (47.80%), followed by consumer discretionary (23.80%) and industrials (10.80%). Energy stocks, health care and utility stocks make up only 8.9% of the fund's value.

The fund's average annual return over five years (before capital gains taxes) was 12% as of May 2023, easily outpacing the S&P 500. However, if tech stocks continue to march higher in 2023, the fund could continue trending upward with a YTD of 20.95%, which is still significantly more than the S&P 500. Now might be a good time for investors to reap good returns in the future.

Index Funds vs. Mutual Funds

Both index and mutual funds typically invest in stocks, bonds and other profitable securities like real estate and ETFs. They primarily differ in their investment approach — how they invest your money. Index funds target a specific list of securities (such as stocks of Nasdaq-100 companies only) and passively invest your capital according to a preset formula. In contrast, mutual funds invest in a dynamic list of securities hand-picked by an investment manager.

An index fund's sole investment goal is to replicate the performance of the underlying benchmark index. For instance, an S&P 500 index fund moves in lockstep with the S&P 500 so that when the S&P 500 fluctuates, so does an S&P 500 index fund. Unlike an index fund, a mutual fund actively seeks to outperform market averages and return higher ROI by investing in strategic investments cherry-picked by the fund's manager as per their expert judgment.

Investors looking to outperform the market index may prefer an actively managed fund over an index fund. However, you'll be paying a higher price for the manager's expertise, which brings us to the significant cost difference between stock index funds and actively managed mutual funds.

When you're investing in a mutual fund, you're not only paying for brokerage services, but unlike index funds, you're also paying the fund manager for their services. The managing entity's expenses — such as investment manager salaries, bonuses, employee benefits and office space — are bundled into a fee you'll have to pay. The fee is known as a mutual fund's expenses ratio. On average, a mutual fund's expense ratio (0.82%) is almost 10 times more than that of an index fund (0.09%).

Index and mutual funds have their selling points and weak points, with the significant differences being their investment strategy and overall investment costs.

Low Risk Diversification

Index funds can be a reliable and low-risk investment option for long-term growth and diversification. They track benchmark indices, offer broad diversification and have low expense ratios. Possible index funds include Fidelity ZERO Large Cap Index, Schwab S&P 500 Index Fund, SPDR S&P 500 ETF Trust, Invesco QQQ Trust ETF and Vanguard Growth ETF. It's important to align investment objectives with chosen funds and consider factors such as expense ratios, asset composition and risk tolerance. Index funds can be a compelling option for investors seeking diversified, low-cost investments that track specific market segments.

Where to Buy Index Funds

Benzinga analyzes, reviews and provides valuable insights on index funds, mutual funds, ETFs and individual stocks of companies, including technology, insurance, finance, cannabis and virtual payment platforms. Compare index fund brokers below.

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