What is an index fund?

Read enough personal finance advice, and you'll notice a few recurring themes. One of those themes is index fund investing: buying shares of a low-cost mutual fund or exchange traded fund that tracks a major stock market index. So what is an index? What is an index fund? And why might you choose a fund over owning stock directly? I'll try my best to answer in this post.

What is an index?

An index tracks the market value and price performance of a portfolio of companies. The Dow Jones Industrial Average and S&P 500 are two of the best-known indices. The Dow Jones Industrial Average is is a price-weighted measure of 30 U.S. blue-chip companies, while the S&P 500 tracks the 500 largest companies by market capitalization. Other indices may track the performance of small corporations (such as the Russell 2000), international publicly-traded corporations, or dollar-denominated U.S. bonds. Indices are typically managed by research and analytics firms.

What is an index fund?

It's a mutual fund or exchange-traded fund that tracks an index. For example, SPDR Dow Jones Industrial Average ETF Trust holds shares of the thirty companies that make up the Dow Jones Industrial Average. In fact, it's the only exchange traded fund that does. Vanguard has both a mutual fund and an exchange traded fund that track the S&P 500.

Why choose an index fund?

Similar to bond funds, index funds give you more diversification bang for the buck. You don't have to construct your own portfolio. You just buy shares of the fund. It's far less risky than buying shares in individual companies because the diversification is built in.

I really like S&P 500 index funds. About 80 percent of growth in equities comes from companies in the S&P 500. With an S&P 500 index fund, you're pretty much guaranteed to meet the market — that is, to earn returns that match the broader stock market. It's hard to beat the market, particularly over the long term. Doing as well as the market means you're doing pretty well.

If you're interested in small-cap stocks, look at the iShares Russell 2000 ETF or Vanguard Russell 2000 Index Fund ETF. Both track the Russell 2000 small cap index. Also check out the Vanguard S&P Small-Cap 600 ETF which tracks S&P 600 index. Keep in mind, that these small-cap funds have higher expense ratios than most S&P 500 index funds.

Why you might prefer individual stocks

There are reasons to own stocks directly. For starters, when you own shares directly, you get a say in how the corporation is run. Granted, you don't get all that much of a say. After all, you're voting your handful of shares against the hundreds or thousands of shares owned by major funds and deep-pocketed billionaires. I kind of like being a grumpy middle-aged person yelling at clouds, so I like directly owning shares, even if my vote is futile.

Direct ownership also means that all dividends and capital gains or losses are yours. Mutual funds and exchange-traded funds charge you for the privilege of managing your money. You may pay a commission when you trade individual stocks, but there's no expense ratio. You also aren't subject to withdrawal limits if you want to sell all of your shares. Some mutual funds limit how much you can pull out of the fund at once.¹

You also get to choose your allocation when you directly own shares. If you don't want to own shares of Tesla or Chevron, you don't have to buy them. With an index fund, you may have exposure to both of those companies.

If your index fund is a mutual fund, you may also receive year-end capital gains And finally, index funds typically have end-of-year distributions. These distributions may increase your income, and your tax bill. Direct ownership means that you have control over whether and when to realize a gain or loss. You can manage if and when you receive dividends. There are fewer surprises. Exchange-traded funds, on the other hand, generally do not create capital gains distributions. They're more tax-efficient. If you hold your mutual fund in a non-taxable account such as an IRA or 401(k), this is not really a concern. (Read Mutual funds vs ETFs for more.)

Which should you choose?

¿Porque no los dos? I think index funds are the smart, easy place to put your money. That said, sometimes I like to do stupid things. A good 15 percent or so of the positions in our portfolio are directly-owned shares. That's a risk we can afford to take.

If you'd rather not do the work of researching individual companies, or don't have the stomach for my highly-effective "Well let's buy it and see what happens!" approach, stick to index funds. Choose funds with low expense ratios. Funds from Vanguard, Fidelity, and iShares generally fit the bill.