How Index Mutual Funds Work

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Index Fund Center

How Index Mutual Funds Work

Aaron Levitt Oct 03, 2014

When it comes to mutual funds, there are basically two flavors: active management and index funds. Most beginning investors understand the idea of active management, where you are basically paying someone to pick and choose what stocks, bonds or other assets the mutual fund will hold. The basic foundation of mutual funds was built on this idea.
However, index funds continue to rake-in big dollars as investors—both retail and institutional—continue to be drawn the fund-types’ many benefits. But what exactly is an index fund? And are the benefits of using them really that worth it for our portfolios? Read on to find out.

Be sure to also read the 7 Questions to Ask When Buying a Mutual Fund

Index Funds 101

What if I told you that you could own every stock in the United States within one single fund? Well, with an index fund you can. The basic idea is that index funds will seek to track a particular benchmark or index as closely as possible. It accomplishes this by buying all of the securities tied to that specific index – whether they’re good or bad. Some big-name and often quoted indexes that investors may be familiar with include the S&P 500, Dow Jones Industrials or the NASDAQ 100. However, this is a just a sampling of the variety of benchmarks out there.

Index funds differ from traditional mutual funds in that there is no active stock selection. There is no fund manager scouring through prospectuses and earnings reports trying to figure out which stocks or bonds may be better bets than the overall market. Index funds just represent that overall market or a particular market segment.

While that may seem boring and a waste of investors’ time and capital, there are some big benefits to just tracking the market or a particular sector in its entirety.

The biggest benefit is outperformance. One of the biggest issues with actively managed mutual funds is that most fund managers actually underperform the broad stock market over time. In fact, over the last 10 years, less than 20% of actively managed diversified large-cap mutual funds have outperformed the S&P 500 index. By buying a broad-market index fund that matches the benchmark you’re seeking to track, you get a return that is as close as possible to that index. This means you’ll beat the vast majority of mutual fund managers out there.

Another reason why you should consider index funds is their low costs. Because all the constituents of a benchmark index are known, it costs far less to run an index fund. You don’t need an army of highly paid CFA-certified analysts digging through the market to pick stocks or bonds. That means there is more money from your investment earning returns rather than paying for a manager’s new BMW. Those low fees help on the outperformance front as well.

See also The Cheapest Mutual Funds for Every Investment Objective

Another added benefit is index funds’ tax efficiency. Since broad index funds just simply buy and hold the stocks in their benchmark, there isn’t much in the way of trading or portfolio turnover. These events can produce capital gains—both long and short- that shareholders must deal with come tax time. Index funds generally don’t have these.

Learn more about How Mutual Funds are Taxed

The Three Biggest Index funds

As the leader and inventor of index funds, it should come as no surprise that mutual fund powerhouse Vanguard is the sponsor of the three largest index mutual funds in the U.S.: The Total Stock Market Index Fund VTSMX, the S&P 500 Index Fund Investor Shares VFINX and the Total International Stock Index Fund Investor Shares VGTSX.

Like their names imply, both VGTSX and VTSMX offer a total market approach to both U.S. and International stocks. VTSMX tracks CRSP US Total Market Index – which includes all the large, mid-, and small-cap stocks in the United States. That’s currently 3742 different firms. Likewise, VGTSX tracks a similar all inclusive benchmark—the FTSE Global All Cap ex US Index—for international stocks. Tracking all market-caps across both developed and emerging market nations, VGTSX holds a whopping 5,667 holdings. Add in their dirt cheap expense ratios and it’s easy to see how they have managed to accumulate $401 billion and $133.4 billion in assets under management, respectively.

Take a look Under the Hood of the Most Popular Mutual Funds

As the first index fund ever created, VFINX is still the preferred method for gaining exposure for U.S. large-cap stocks for many investors. The fund has nearly $368 billion in assets. And as the name says, the mutual fund uses a full replication strategy to track the venerable S&P 500 index. Expenses run a dirt cheap 0.17% – even cheaper for other share classes of the fund.

Other Considerations for Index Funds

Even in the world of index funds, there can be nuances you should look out for.

A big one is whether or not an index fund uses a full replication or sampling strategy to derive its holdings. In a full replication strategy, the fund will buy all the stocks within its chosen benchmark; it’ll own all 500 stocks in the S&P 500. In a sampling strategy, the mutual fund will buy most, but not necessarily all, of the stocks within the benchmark index. The idea is that the fund will attempt to closely match the overall investment attributes of the index. A fund manager will make the overall selections to keep sector weightings and provide a large spread of firms to cover the underlying index. Generally, a sampling approach is used on some international and emerging market index funds where buying all the stocks may prove difficult.

Another concern for investors is fees. While index funds are known for being cheap, not all of them are. Some still come with high expense ratios and sales loads. For example, the Rydex S&P 500 A (RYSOX) charges a huge 1.57% in expenses as well as 4.75% sales load. That’s raw deal for investors. There’s no reason to pay more than 0.40% in expenses for an index fund at this point.

Also on the fee front is brokerage account commissions. A lot of the best and well known index funds come with transaction fees at many of the low cost online brokerage firms. It may be better for investors to buy them direct from the mutual fund companies themselves and save on the fees.

The Bottom Line

For most individual investors, index funds are a great bet. By tracking a specific benchmark they overcome many of the problems with active management. Add in their low costs & their long term outperformance and you have a recipe for investment success. Just keep it simple and watch out for fees, and index funds could be your portfolio’s best friend.

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