What are index funds? A beginner’s overview

We’d all like to make money on the stock market, right? However, busy families often lack the time to monitor markets and portfolios, or are understandably afraid to make costly mistakes. Enter index funds, which have become popular investing tools for these very reasons. 

Typically in the form of mutual funds or ETFs, index funds are passive investment vehicles that aim to replicate the performance of a particular market index ( a pool of stocks representing a specific part of the stock market). 

How index funds work

In simple terms, imagine that a market index is like a bestseller list for a particular market segment. For example, the S&P 500 comprises the 500 largest publicly traded companies in the U.S. You could buy stock in each of these companies separately, but it would be tough to keep track of how each stock performs as the S&P 500 changes over time. 

An index fund buys small portions of all the companies in an index and automatically adjusts as those companies grow or shrink. In other words, when you purchase an index fund, you’re essentially following the average performance of that market segment, without any extra work required.

#1 family finance and safety app.

#1 family finance and safety app.

Teach your kids and teens to earn, save, and invest with Greenlight.

Use code GLBLOG for one month, on us.*

Try Greenlight today

Advantages of index funds

Index funds provide a few advantages for investors:

• Simplicity and accessibility: All you need to do is buy shares of one index fund to access the performance of that entire index. 

• Diversification: Even though you’re buying just one fund, you get built-in diversification since it includes many companies across the market index. 

• Lower cost: Index funds don’t have human fund managers. They’re run by algorithms that track the index, which keeps fees and costs very low compared to some other investment options. 

• Tax efficiency: Index funds only buy and sell stocks when the index itself changes. This limited trading helps keep taxes lower for investors. Index fund ETFs also have additional tax efficiency advantages for investors. 

Drawbacks and limitations

With all of these advantages, there are still drawbacks and limitations to consider, including:

• Can’t beat the index: Some investors want to outperform the index with their own investing strategy. Because index funds are designed to match the index’s performance (minus small fees), your returns will be the same or slightly lower, but never higher.

• Market downturn exposure. Since your investments move with the overall market, you can’t make individual changes to offset losses when the market dips.

• Tracking errors. While index funds aim to track the index directly, in reality, this is often not the case. Timing differences between the index’s adjustments and the fund’s fees and transaction costs can drag the fund’s returns down, among other factors. 

Types of index funds

There are hundreds of different market indexes that index funds can follow, each representing a unique piece of the market. Investors may be familiar with the most common ones, like the S&P 500, the Russell 2000 for small-cap U.S. stocks, and the Nasdaq 100 for the largest technology companies. However, there are many more, including ones that cover specific industries, geographical regions, bond types, and investment strategies. 

How to choose an index fund

To decide which index fund to invest in, there are a few things to consider:

• Index: Which index is the fund tracking, and what is its methodology for tracking it?

• Fees: What are the fund’s fees and expense ratio?

• Historical performance: Does the fund’s performance stay close to the index it follows, or does it often fall behind?

• Minimum investment: Can you afford the buy-in minimum amount?

• Reputation: Is the fund managed by a reputable provider? How large is the fund?

• Goals: What are my goals, and which index funds align with these goals?

Boost your investment game with Greenlight

Greenlight’s educational investing app gives families an easy way to start with index funds. Kids can learn the basics, like diversification and compounding growth, and research companies. Parents oversee and approve any trade. With access to real stocks and ETFs, including index funds, you can practice building a portfolio together in a safe, educational environment.

Who index funds might be right for

Index funds can be a good starting point or a valuable addition to a portfolio for many investors. Here are a few factors that could make it a good fit:

• Investors seeking low-cost options.

• Long-term investors looking for simplicity and “set-it-and-forget-it” options.

• Beginners looking for ways to diversify as they learn the stock market and build their portfolio. 

Index funds can be an excellent tool for investors

If you’re looking for straightforward, low-cost ways to invest, then index funds are something worth considering for your investment portfolio. Ensure you pick funds that align with your personal goals and risk tolerance, while building your portfolio.

Want to raise savvy investors? With Greenlight, kids get real-world experience under your guidance. Try Greenlight, one month, risk-free.†