Index Funds: What Are They and Why Do People Love Them?

Investing is often intimidating for many people. They might receive a list of funds from their 401(k) company and find the names of the funds confusing. For example, you may have no idea what is meant by words like index, small-cap, global, or other terms.

However, it's important to at least have a basic understanding of these terms. Investing too heavily in one area can have long-term consequences for your portfolio.

Fortunately, a little education goes a long way. Let's talk about index funds--how they are different than actively managed funds and why many people find them to be a good strategy.

What is an index?

First, let's discuss the definition of an index. An index is a broad measure of a section of the stock market. You may have seen or heard of people talking about the S&P 500, the Dow Jones Industrial Average (DJIA, or often just called the Dow), or the NASDAQ. These are examples of indices of the stock market. Many people consider the S&P 500 to be the standard, as it measures the performance of the 500 largest companies in the United States.

These aren't the only indices. There are also indices that measure the performance of mid-size companies (S&P 400), smaller companies (Russell 2000), or developed international markets (EAFE).

Indices can still go even deeper. Indices exist that measure specific sectors of the market, including pharmacy, technology, retail, and more.

While the S&P 500 comes to most people's minds, it's important to recognize other indices as they can play an important role in your investment strategy. 

What is an index fund?

An index fund attempts to replicate the performance of a specific index. Index funds can be mutual funds or Exchange Trade Funds (ETFs). This means if an index moves up 1%, the fund will move up 1%. The opposite is also true.

Index funds are passively managed, meaning fund managers don't have to do much trading within the fund. They just need to keep an eye on the stocks within the fund to make sure they match the given index.

Because index funds are passively managed, they tend to be far cheaper for the investor. To put this in perspective, an actively managed fund may charge 0.75% per year for managing a fund. This would equate to $75 for every $10,000 managed by the fund.

Conversely, an index fund might charge 0.05%, or $5 for every $10,000 managed by the fund. This could result in thousands of dollars saved over the course of 30 years of investing.

Furthermore, because there is little in the way of trading within the fund, there is very little turnover of the stocks inside the fund. This is a big deal for taxable brokerage accounts. When you own a mutual fund or an ETF, any capital gains from the buying and selling of stocks within the fund are passed through to the investors. Because of the passive nature of index funds, there are relatively few capital gains. This makes them far more tax-efficient for taxable accounts.

What is an actively managed fund?

Actively managed funds attempt to meet a given objective. Most commonly, they attempt to outperform a benchmark index in the stock market. As an example, an actively managed large-cap fund might try to beat the S&P 500 in a given year.

However, it would be too simplistic to say the only thing they do is try to beat the market. Some funds also have objectives that include generating income for investors or investing according to a certain set of values. For example, some funds attempt to serve Christians by filtering out companies that sell tobacco, alcohol, or pornography.

As noted earlier, actively managed funds tend to be more expensive. This stems from the fund companies hiring experts to continuously manage the funds.

Unlike index funds, actively managed funds have the potential to outperform their benchmark. Unfortunately, this is where it can be a bit of a mixed bag. In some years, they may be able to substantially outperform the market. But few funds have ever been able to do so consistently.

Should I invest in index funds?

People love index funds because of many of the reasons listed above. They're cheap, tax-efficient, and will never underperform their index. This makes them attractive and a strong long-term group of investments.

In general, index funds can be a great way to start investing. But you should also know that it's not as "set it and forget it" as you might think. There are a lot of different indices, and you should still have a good mix of index funds that should change as you get closer to retirement.

As a side note, actively managed funds aren't necessarily bad. It all depends on your goals and values. There may be instances where actively managed funds would serve you better.

The most important thing is to make sure you start investing now. If you need help, I recommend talking with a Kingdom Advisor. These are men and women who look at your finances from a biblical worldview and would advise you on the best way to allocate your investments.

About the author: Jon Matlock serves as a financial planner at American Financial Planning, Inc. in Roanoke, Virginia. He is a CFP® candidate, a professional member of Kingdom Advisors, and a graduate of Southeastern Seminary. Before pursuing financial planning, Jon served overseas with the International Mission Board and also worked in their Church Success Center. In his free time, Jon enjoys serving his church, hiking in the beautiful Roanoke Valley, and spending time with his wife and son.