An index fund is an investment fund containing the companies that are listed on a major stock market index. To answer the question “What is an index fund?” fully, we'll discover what an index is and what a fund is to give you a better understanding of the term index fund.
I'll also show you some popular indices along with popular index funds that track the respective indices.
Definition of An Index Fund
In order to understand what an index fund is, you need to understand what an index is first. One of the definitions of “index” by the Oxford Language Dictionary is:
“An indicator, sign, or measure of something.”www.Lexico.com – Powered by Oxford
A stock market index is a way of measuring the performance of the stock market as a whole or of a particular industry or sector within the stock market.
To do this, reputable investors have compiled a group of companies within a particular industry or sector aggregating the performance of all the companies as one. Being able to see how the aggregate performance of these companies plays out gives investors the ability to estimate the performance of that industry or sector.
If you want to measure the entire stock market, most people refer to the S&P 500 index, which is an index compiled of 500 of the largest companies that trade in the US, and make up over 80% of the entire stock market. How the S&P 500 performs gives investors a fairly good idea of how the whole US stock market is performing on any given time frame.
A fund is simply a group of companies compiled together and managed by an investment company where investors can choose to purchase shares or ownership in that fund.
Putting the two together, an index fund is simply an investment fund that includes all the companies in a particular index available for investors to purchase. So, the S&P 500 can be copied by investment companies and offered to their clients as a fund to invest in.
Popular Stock Market Indices
Some of the most common indexes used by investors on a daily basis were made to track the performance of major sectors of the stock market. They include:
S&P 500 Index
Standard & Poor's 500 Index, or S&P 500 Index, is a market cap weighted index fund that includes 500 of the largest companies by market capitalization (aka market cap) traded in the US.
Investors often refer to the S&P 500 index as a way to measure how the total US stock market is performing on any given time frame.
Dow Jones Industrial Average Index (DJIA)
The Dow Jones Industrial Average, or DJIA, is an index created by Charles Dow in 1896 that simply includes 30 large blue-chip stocks that either trade on the NYSE or the NASDAQ stock exchanges.
It was created to serve as a measure of the overall health of the stock market and includes large companies who are well established and well known, like Microsoft and Walt Disney.
It is one of the oldest indexes used by stock market investors.
The NASDAQ Composite Index
The NASDAQ Composite Index is a market cap weighted index that includes over 2,500 equity investments that trade on the NASDAQ stock exchange. It includes investments such as common stocks, American Depository Receipts (ADRs), and Real Estate Investment Trusts (REITs).
NASDAQ stands for National Association of Securities Dealers Automated Quotations exchange. It was the first electronic index allowing investors to purchase shares of companies electronically. The exchange has mainly technology and internet-based stocks, and thus the NASDAQ can be referred to as a good way to measure technology and internet-based companies.
Russell 2000 Index
The Russell 2000 index contains 2000 of the smallest American companies by market cap that are included in the Russell 3000. The Russell 3000 contains 3000 of the largest American companies by market cap.
This index provides insight into how well the small cap companies within the US are performing as a whole.
Popular Stock Market Index Funds
While the above three stock market indices are used to measure different areas of the stock market, there are also funds available for investors to invest in that match the companies included in an index fund such as the ones discussed above.
You can purchase shares of an Exchange Traded Fund (ETF) that matches an index, or shares of an index mutual fund that match a specific index. I recommend purchasing ETFs due to their lower costs and simplicity.
Related Article: What's The Difference Between An ETF And A Mutual Fund?
S&P 500 Index ETFs
If you want to invest in a fund that matches the S&P 500 index, you can buy shares of ETFs like:
- iShares Core S&P 500 ETF (ticker symbol IVV) – An index ETF offered by BlackRock that matches the S&P 500 index.
- Vanguard S&P 500 ETF (ticker symbol VOO) – An index ETF offered by Vanguard that matches the S&P 500 index.
- SPDR Portfolio S&P 500 ETF (ticker symbol SPLG) – An index ETF offered by SPDR that matches the S&P 500 index.
Dow Jones Industrial Average Index ETFs
If you want to invest in a fund that matches the DJIA index, consider purchasing shares of ETFs like:
- SPDR Dow Jones Industrial Average ETF (ticker symbol DIA) – An index ETF offered by SPDR that matches the DJIA index.
- iShares Dow Jones US ETF (ticker symbol IYY) – An index ETF offered by BlackRock that matches the DJIA index.
NASDAQ Composite Index ETFs
If you want to invest in a fund that matches the NASDAQ composite, consider purchasing shares of ETFs like:
- Fidelity NASDAQ Composite Index ETF (ticker symbol ONEQ) – An index ETF offered by Fidelity that matches the NASDAQ composite index.
- Invesco QQQ ETF (ticker symbol QQQ) – An index ETF offered by Invesco that closely matches the NASDAQ composite index. This ETF matches the NASDAQ-100 which is a more focused ETF on approximately 100 of the companies listed on the NASDAQ.
Russell 2000 Index ETFs
If you want to invest in an index fund that matches the Russell 2000 index, take a look at some popular ETFs that match this index such as:
- iShares Russell 2000 ETF (ticker symbol IWM) – An index ETF offered by BlackRock that matches the Russell 2000 market index.
- Vanguard Russell 2000 ETF (ticker symbol VTWO) – An index ETF offered by Vanguard that matches the Russell 2000 market index.
Why Invest in Index Funds?
Why would anyone want to invest in an index fund? Some investors prefer to invest in stocks on a passive manner, meaning they invest their money in a fund and then set it and forget it. They don't want the hassle of spending extra time tracking and managing their stocks, so they invest in an index. But, why an index?
As a passive investor, your goal is mainly to achieve the average return of the overall stock market, give or take a few basis points. The stock market as a whole has produced an average of roughly 10% annually. By investing in an index ETF like the Vanguard S&P 500 ETF, you can expect to achieve a similar return over the long run.
The index ETFs are managed and update automatically if the companies within the respective index change, eliminating the need for you to actively manage your portfolio.
Investing in an index ETF also diversifies your investment portfolio by nature. One share of the Vanguard S&P 500 ETF means you own shares in 500 companies. If one company does bad and goes bankrupt, you won't lose your whole portfolio because you have 499 other companies that can compensate the difference.
Related Article: What Does It Mean To Diversify Your Portfolio?
When you invest in an index ETF, you already know with a pretty high degree of certainty what your expected annual return is. How? ETFs like the S&P 500, the DJIA index and the NASDAQ composite have been around for decades or more, and thus we know their average returns.
How and Where to Invest in Index Funds
If you already have an individual investing account, all you need to do is type in the ticker symbol shown above for the respective ETF and begin making purchases into that fund.
If you don't have an individual investing account yet, then you first need to open an account. Almost anywhere you go these days, opening an investing account (aka brokerage account) is free and takes less than 10 minutes. After your account is open, simply type in the ticker symbol of the index ETF you want to invest in and make your first purchase!
I recommend opening an individual investing account with one of the following companies:
M1 Finance lets you invest in the stock market for free and with no minimum balances. You can create your own “pie” or fund with your favorite companies or choose an expert fund or ETF to add to your portfolio.
Public is an investing app that lets you invest in stocks and ETFs for free. They are more of a “social investing” app that lets you share your portfolio with others and see public portfolios of those you follow.
Acorns is more of a robo advisor investing app that creates a customized portfolio for you based on your answer to some basic investment questions. Within the portfolio includes different ETFs and funds that may include index funds, depending on your investing risk tolerance.
They also let you link your bank account and round up each of your daily purchases to the next dollar and invest the spare change automatically into your customized portfolio.