Investing

Understanding Index Funds

Funds that track the market may have lower costs, but should investors consider other options?

by Mark Tosczak - December 11, 2017

Every business day, the media report what happened in the financial markets. Was the Standard & Poor’s (S&P) 500® or the Dow Jones Industrial Average® up or down for the day? Did the Russell 2000® — which measures small-cap U.S. stocks — strengthen or weaken?

While those numbers tell investors something about the financial markets, they don’t necessarily tell how individual portfolios performed. After all, the S&P 500 has 500 companies in it, and though considered a good representation of U.S. equities, it doesn’t necessarily represent individual portfolios.

For most individual investors, accumulating shares of all the companies in the right proportions to match the S&P 500 is prohibitively expensive. Or at least it was, until the mid-1970s when a new investment vehicle appeared.

“Index funds came along and tried to fill that void, almost tried to democratize investing,” says Sameer Samana, Global Quantitative Strategist at Wells Fargo Investment Institute. “The way most people should think about index funds is as broad, passive, cheap vehicles.”

An index fund allows you to maintain a dynamic allocation that evolves over time as the economy evolves.

What is an index fund?

Index funds are a form of passive management, where the fund replicates the performance of a specific index of investments. One of the primary strategic advantages of index funds is that they typically have low operating expenses. It’s the opposite of active management, where a portfolio manager tries to pick selected equities or investment vehicles that will outperform during a specific period of time.

Index funds got their start in the mid-1970s, as mutual fund companies realized that for most investors, buying shares of everything in the S&P 500 was cost-prohibitive. As more people invested in these index funds, managers developed funds for additional indices.

“What an index fund allows you to do is maintain a dynamic allocation that evolves over time as the economy evolves,” Samana says.

In the beginning, index funds were weighted by the market capitalization of the stocks comprising the index. When that resulted in some of those indices being overinvested in pricier stocks, Samana says people started coming up with alternative weighting factors, such as revenue and valuation, in the hopes of preventing investors from being concentrated in the most expensive stocks.

Investing in low-cost, passive index funds — even in efficient asset sectors such as U.S. large-cap stocks — isn’t a solution to all investing needs.

Passive or active management?

Proponents of index funds and passive management principles generally argue that over time these kinds of funds, which reflect the market sentiment, will outperform an actively managed fund. Others have the opposite sentiment.

“Some people would have you believe that active management is the only way to go,” Samana says. “They spend a lot of time looking for the right active managers.”

But active management is controversial. It’s typically more expensive than an index fund, because it requires more work on the part of active managers. Expense ratios are typically higher for active-management funds, meaning that in order to beat an index, it needs to outperform it by more than the difference in operating expenses. Many investing theorists believe active managers can’t consistently match or beat broad market return rates, especially after factoring in fees.

But there may be many cases where active management works out better, Samana notes.

Samana explains, “When you step away from large caps, which would include the bulk of the companies in the widely known S&P 500, and venture into areas such as small-cap stocks or emerging markets where individual security information isn’t as readily available and may require more research, you start to see where value is really added by active management in some of these areas of the market.”

Samana also notes that in terms of investor options, index funds for equities are still far ahead of those available for debt.

And, Samana notes, simply investing in low-cost, passive index funds — even in efficient asset sectors such as U.S. large-cap stocks — isn’t a solution to all investing needs.

Instead, work with your advisor to craft your portfolio and determine your asset allocation based on your investment goals and risk tolerance. Just like you wouldn’t want to only own one equity, you may not want to solely rely on one strategy — passive or active.

Mark Tosczak has spent 25 years wrangling words for newspapers, magazines, businesses, nonprofits, and other organizations. He focuses on health care, science, and business.

Image by iStock

Additional Resources

How well do you understand large-cap stocks and small-cap stocks? Learn more.

Risk Considerations

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. The prices of small and mid-cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Exchange Traded Funds seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched. Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Definitions

Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

An index is unmanaged and not available for direct investment.

Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Opinions represent WFII’s opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not an offer to buy or sell or solicitation of an offer to buy or sell any securities mentioned. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs, and investment time horizon.