Index Funds Explained

by: BlackRock

By BlackRock

Indexing strategies have been around for decades, but many investors still don't fully understand what a powerful tool they can be when constructing a portfolio. Indexing serves as a cost-effective way to potentially achieve long-term goals. From pensions and defined-contribution plans, to individuals and their financial advisors, all types of investors can gain access to broad market opportunities that indexing offers.

The first index funds were created in the 1970s, and their popularity has steadily increased to this day. In fact, investment into index strategies has continued to grow even as actively managed mutual funds have seen outflows.

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What is an index?

Think about a stock index as "the market." An equity index provides exposure to a relatively large number of stocks that represent a particular market. And there are different kinds of indexes to choose from. Some broadly cover the markets, for example the S&P 500 or the Russell 2000. An index may represent only large-cap stocks or only small-caps, or both. Some indexes cover international markets or specific sectors, such as financial companies or U.S. technology. The same holds true for bond indexes, if you're looking for income.

In summary, if you are buying an index fund, you are effectively investing in the market.

How stock indexes fit in a portfolio

When thinking about the mix of assets in your portfolio, consider the risks that you are willing to take over a particular time period to realize your goals. For example, if you're hoping for an early retirement or are saving to send your young child to college someday, you will likely need to have a core allocation to stocks over the long term.

What does core mean? It effectively means long-term "buy and hold" positions in your portfolio. Why stocks? Because the value of money erodes over time as inflation drives prices higher and pushes down the purchasing power of your dollars. To put that in perspective, a dollar earned in 2000 would now be worth 74 cents, and a dollar from 1980 amounts to just 35 cents today, according to the U.S. Bureau of Labor Statistics CPI Inflation Calculator.

On their own, stocks historically carry more market risk than cash and bonds. In the short term, stock prices can be volatile. But in return for this increased risk, there is the potential for a higher return.

But which stocks are the best to own over a long period of time? It's difficult even for the pros to know exactly which stocks to buy when. Here's where the beauty of stock indexes come in. Exchange traded funds (ETFs) and index mutual funds can be an effective way to buy the market in a low-cost, tax efficient manner and help you keep more of what you earn.

Portfolio construction is a lot like building a house. You need a strong foundation or else your house will fall over. Index funds can serve as the concrete blocks of your portfolio foundation so that your investment plan can stand the test of time.

Questions to ask

The quality of the index composition and the fund manager who runs it play crucial roles in determining your overall performance. In addition, the structure of the funds you choose can significantly affect your portfolio's tax efficiency and ability to sell when you want to.

When evaluating index fund managers, consider these questions:

  • What trading strategies do they use to maneuver in changing markets?
  • How tax efficient are these products?
  • What's the quality of the benchmark the fund seeks to track, and how does it compare to others?

There are many tools to consider in portfolio construction and asset allocation, but having a core of index strategies can be instrumental to potentially achieving long-term portfolio growth and the outcomes you desire.

This post originally appeared on the BlackRock Blog.