A Quick Guide to Index Funds

For smaller investors, an index fund is one of the most prudent investment vehicles available. Since the first index fund was created by Charles Dow in 1896, index funds have been championed by numerous investing luminaries, such as Vanguard Group CEO John C. Bogle, as one of the smartest ways to invest. Getting started with index funds is simple, but it's important to educate yourself about the various risks and benefits involved.

What are index funds? An index fund is a type of investment fund, usually structured like an ETF or mutual fund, that's been especially constructed to match or track the components of a market index, such as the S&P 500 and Dow Jones Industrial Average.

These holdings can either be exactly proportional to the underlying index or sampled to provide a similar investment risk-return profile, explains Raphael Mennicken, chief investment officer of online investment management platform Covestor.

"Investment decisions are transparent [and] typically based upon rules to ensure similar market exposure as the index," he says.

Why index funds? There are a variety of benefits associated with index funds. The primary advantage, Mennicken explains, is that an investor can expect a risk-return profile similar to the index being tracked, which is usually a diverse portfolio. This reduces the risk of stock-specific events causing large drawdowns.

Since index funds are passively managed, they provide broad stock market exposure without the higher operating expenses associated with actively managed funds, as well as excellent tax efficiency.

"Index funds are often lower cost, as investment decisions use less expensive research, analysis and specialist portfolio management and trading techniques," says Mennicken. "They also have a low turnover, thus saving on costs of trading."

Risk factors Despite these benefits, however, index funds still carry with them a number of risks and pitfalls.

"Index returns are not matched exactly, due to fees, rebalance costs and the need to hold a small amount of cash," Mennicken explains. In addition, hybrid instruments that are similar to index funds exist, such as enhanced or synthetic indexing funds, which may contain derivatives.

Another drawback is that index funds can also offer limited flexibility for investors. Mennicken notes, "Fund managers do not have the ability to move the portfolio to more defensive positioning if they are concerned about upcoming market conditions."

Getting started To begin investing in index funds, you have two main options. You can either invest in a fund directly through the mutual fund family or using a brokerage account. No matter which route you choose, you'll need to understand all the risks involved before taking the plunge.

Investors should decide whether to use index funds to gain exposure to specific financial markets or use a combination of index funds to gain diverse global exposure across asset classes. It's also crucial to examine all the details before investing in a particular index fund.

"Many websites exist that provide information about index funds, including costs, tracking error (how closely the index's performance mimics that of the underlying benchmark), and other parameters," Mennicken says.