The pros and cons of index funds
Editorial staff, J.P. Morgan Wealth Management
- An index fund is an investment vehicle, either an exchange-traded fund (ETF) or a mutual fund, that tracks the performance of a market index.
- Index funds often come with low fees and built-in diversification, but their returns may be lower than those of actively managed funds (although not always).
- You should consider your financial goals and risk tolerance before choosing an index fund to add to your portfolio.
Index funds have grown in popularity in recent years as a simple, low-cost investment option. They’re designed to track the returns of a market index, making them a mostly passive investment strategy.
Let’s consider how index funds work, the different types available and how to choose the right ones for your financial goals.
What are index funds?
An index fund is an investment vehicle that tracks the performance of a market index, like the S&P 500. Instead of trying to beat the market, index funds attempt to match the returns of the index they follow by holding the same securities or a basket of securities designed to mimic the index’s performance. For example, an S&P 500 index fund may hold shares of the same 500 companies that make up the S&P 500 or a sampling of companies in the S&P 500 to mimic its performance.
Unlike actively managed funds, where a portfolio manager decides to buy or sell certain assets, index funds are likely more passively managed, which may help keep costs low. Index funds also have built-in diversification, since each fund holds a wide mix of securities, although the amount of diversification will vary based on the index the fund is tracking.
Index funds come in two different forms – ETFs and mutual funds. Both track a specific index, but ETFs trade like stocks on an exchange throughout the day, while mutual funds are bought and sold at a set price once per day.,
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Types of index funds
There are many different categories of index funds. Here are some of the most common.
Stock index funds
Stock-focused index funds track a specific stock market index, like the S&P 500 or the Dow Jones Industrial Average. These funds invest in the same companies that make up the index or a sampling of companies in the index to mimic its performance. Stock index funds may be a good choice for investors looking to gain exposure to equities without needing to pick stocks of individual companies.
Bond index funds
Bond funds invest in a specific bond market index, like the Bloomberg U.S. Aggregate Bond Index. These funds may include government bonds, corporate bonds or municipal bonds, depending on the index they are tracking. Investing in bond funds can be an effective way to generate steady income and add stability to your portfolio.
International index funds
International index funds track market indexes outside of the U.S. – like the Nikkei 225, the FTSE 100 or the DAX index (to name a few). These funds allow you to diversify outside the U.S., while gaining diversified exposure in the same way you would if you invested in an index fund tracking the S&P 500. However, your investments in international index funds are subject to additional risks – including changes in foreign exchange rates, potential political or economic developments, and differences in regulatory or legal systems – that could affect your returns.
Sector-specific index funds
Sector-specific funds focus on a particular industry or segment of the economy, such as technology, health care or real estate. For example, a technology sector index fund may track the NASDAQ-100 Technology Sector Index or the S&P Technology Select Sector Index. As these funds track indexes that include companies operating within a specific sector, investors are able to gain exposure to a particular sector without needing to pick individual stocks, although they likely offer less diversified exposure than broad stock market index funds.
Benefits of investing in index funds
Index funds are a popular investment option for new and experienced investors alike. Here are some of their biggest benefits:
- Likely low fees and expenses: Index funds are passively managed, so they require less portfolio management and trading than actively managed funds. This likely translates to lower management fees compared to actively managed funds.
- Reduced risk through diversification: Index funds spread your investment across a range of assets. If you’re invested in a stock-focused index fund, for example, one company’s shares could fall, but the other companies in the fund may help mitigate the negative impact on your portfolio. How diversified an index fund is, though, will vary depending on the index it’s tracking.
- Consistent performance over time: Index funds are designed to match an index’s performance – not beat it – so at their best they tend to offer steady, consistent returns over time.
- Ease of management for investors: Index funds are a largely hands-off investment strategy, so they’re ideal for anyone who isn’t interested in constantly researching companies or making frequent trading decisions.
Potential drawbacks of index funds
Despite the many benefits index funds offer, there are downsides to consider as well:
- Limited flexibility in investment choices: Index funds are tied to a specific index, so the holdings won’t change if the fund starts performing poorly.
- Potential for lower returns: Index funds aren’t trying to beat the performance of an index, so they may underperform actively managed funds at certain times.
- Market risk and volatility: Index funds offer diversification, but they’re still subject to market risk, and some are more volatile than others.
Comparing index funds to other investment options
Before investing in index funds, it’s helpful to see how they stack up against other investment vehicles. Here’s how they compare in terms of cost, risk and level of involvement.
Index funds versus actively managed mutual funds
Index funds attempt to replicate the holdings of a benchmark index, while actively managed mutual funds rely on professional managers to select investments. Active funds offer the potential for higher returns, but they often involve higher fees and turnover costs.
Index funds versus individual stocks
Buying individual stocks allows you to invest in specific companies and potentially earn higher returns. This approach also comes with greater risk and requires far more research. A single stock’s performance can be volatile, and choosing the right companies consistently is difficult, even for highly experienced investors.
Index funds, however, offer automatic diversification and reduce the risk tied to investing in any one company. They may not deliver dramatic gains, but they can provide more stability and be easier to manage.
Index funds versus thematic ETFs
Thematic ETFs – sometimes referred to as curated ETFs – focus on specific trends like clean energy or artificial intelligence, which may span multiple sectors. In contrast, sector index funds track the performance of a single sector, such as health care or technology, using a rules-based approach.
Thematic ETFs are more likely to be actively managed, so fund managers have discretion to select companies they believe are best positioned to benefit from an emerging trend or growing sector.
While thematic ETFs offer the opportunity to align your portfolio with specific innovations or values, they can be more volatile and less diversified than index funds. They’re best suited for investors who want targeted exposure and are comfortable taking on higher risk in pursuit of growth.
Why index fund returns may differ
The performance of an index fund is directly tied to its underlying assets, which can vary considerably. The performance of a Nasdaq 100 index fund (made up of the largest non-financial companies listed on the Nasdaq stock exchange, many of them being technology companies) may vary substantially from a SSE index fund (tracking the Shanghai Stock Exchange).
One of the most well-known stock market indexes is the S&P 500 index. The S&P 500 has delivered an average annual return of over 10% since 1957. While past performance doesn’t guarantee future results, this consistency has made S&P 500 index funds a popular choice among investors seeking steady growth.
Consider your risk tolerance and investment timeline when evaluating different index funds. Some index funds may be heavily weighted toward specific sectors or companies, especially if the index is market-cap weighted. Reviewing the fund’s holdings can help you decide if it aligns with your overall financial goals. Not all index funds come with the same upside, underlying diversification or risk profile, so it’s important to consider the pros and cons of each.
How to invest in index funds
Getting started investing in index funds is pretty straightforward. You’ll need an investment account – be it a general purpose brokerage account or a tax-advantaged retirement account like an IRA, which functions as a brokerage account unless managed – to purchase shares of an index fund.
From there, you can choose which index funds to invest in and decide if you want to invest a lump sum or invest based on dollar-cost-averaging (investing in fixed intervals over time).
Choosing the right index funds
Not all index funds are the same, so it’s important to compare your options before investing. In addition to the underlying investments and objectives, another critical factor to consider is the fund’s expense ratio, which is the annual fee charged by the fund. For passively managed funds, this fee can range from 0.02% to 0.25% or even more. While this might seem like a small amount, it can have a significant impact on your returns over the long run.
Beyond fees, you may want to look for funds that don’t have a high minimum investment requirement. You'll also want to decide if you want to invest in an index fund that’s an ETF or an index fund that’s a mutual fund. Some people prefer the automatic investing options that come with mutual funds, while others like the flexibility of ETFs that trade like stocks.
And to reiterate, you’ll want to understand the index the fund is tracking and what its underlying assets are. Some index funds hold large, well-known companies. Others might include small or mid-sized companies, international stocks or bonds.
Matching your investments to your goals
Your financial goals should guide the types of index funds you choose. If you’re saving for a long-term goal like retirement, stock index funds may be a good fit since they may have high growth potential. For short-term goals, a mix of stock and bond funds can offer more stability. You should also consider how much risk you’re comfortable taking on.
No matter what you choose, spreading your money across different types of investments can help protect your portfolio from temporary losses in any one area. And while index funds don’t require a lot of daily attention, it’s a good idea to check your portfolio a couple of times a year to ensure your investments still align with your goals.
The bottom line
Index funds can be a low-maintenance way to grow your money over time thanks to their built-in diversification and low fees. But like any investment, you want to choose funds that fit your timeline, risk tolerance and financial goals.
Frequently asked questions about index funds
Every investment comes with some level of risk, but index funds are generally considered lower risk than buying individual stocks or bonds since they spread your money across different assets. Index funds are only as safe as their underlying assets, though. An index fund tracking the performance of a stock index in an emerging market may be more volatile, for instance, than a broad stock market index fund in a mature economy.
The amount you need to get started depends on the fund – some don’t have any minimum investment requirements, while others may require a set amount to get started.
Yes, index funds can decrease in value just like any investment. While they’re diversified (some more than others), there’s still risk involved.
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Editorial staff, J.P. Morgan Wealth Management
