Pros and Cons of Index Funds

Pros of Index Funds

Index fund managers aim to duplicate the structure and performance of their target index. For example, the Vanguard S&P 500 Index Fund—an index fund for individual investors—invests in every company listed on the S&P 500 index. Many investors include index funds as core pillars of their portfolios because of the many benefits these funds provide, such as the following.

Affordability

Index funds are passively managed rather than actively managed. That means index fund managers have a more hands-off approach and invest passively in companies in the market index it follows. Conversely, actively managed funds require the manager to be more involved in researching and choosing which funds to invest in. Because index fund managers don't trade holdings as often as actively managed funds, their management fees tend to be lower.

For example, the management fees, or expense ratio, for the Fidelity 500 Index Fund is a low 0.015%. That means a $10,000 investment in the fund could enable you to enjoy the diversification of the index at a minor management cost of $1.50 annually.

Diversification

Financial experts consistently advise clients to diversify their portfolios to reduce risk. Since a fund invests in numerous stocks, your portfolio is less likely to be significantly harmed by the poor performance of a single stock.

When you invest in an index fund, you immediately gain access to a large collection of stocks, bonds or other securities, which dilutes your risk. Attempting to accomplish the same diversification to build a similar portfolio on your own would require substantial time and money.

Keep in mind, however, that some indexes are not diversified and invest only in a specific industry or sector.

Long-Term Performance

While performance is never guaranteed, index funds tend to provide more stable and predictable returns over a long-term horizon. Financial advisors have long espoused the long-term benefits of holding index funds for average investors. Accordingly, index funds are often considered an excellent core asset for retirement accounts, including individual retirement accounts (IRAs) and 401(k) accounts.

Billionaire investor and philanthropist Warren Buffett famously advocates for the long-term performance of index funds for the average investor. In a 2013 Shareholder Letter, Buffet revealed his simple instructions for his trustee in his will: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust's long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals—who employ high-fee managers."

Cons of Index Funds

The most popular index funds track large sections of the market. Major indexes these funds track include the S&P 500, the Dow Jones Industrial Average, the Russell 2000 and the Nasdaq Composite Index, but index funds also track much smaller indexes. Investing in a large portfolio of equities does have its downsides, including the following.

Less Flexibility

While your portfolio is less affected by a declining singular asset, it's not immune to the fluctuations of the larger market, including economic downturns and bear markets. As such, when the market or sector performs poorly, your index fund will likely follow suit.

Inherently, index funds don't provide the flexibility to quickly respond when the prices of the assets they hold fall. Accordingly, it may be best to maintain a long view with index funds and be prepared for the fluctuations that are sure to come.

Moderate Annual Returns

A single index fund can hold hundreds or even thousands of assets. For example, the Wilshire 5000 tracks all publicly traded companies in the United States. The fund no longer includes 5,000 companies—it currently has around 3,550. The diversification such a large fund provides is immense, but its size also dilutes the possibility of achieving significant annual returns.

Fewer Opportunities for Short-Term Growth

As noted, index funds are widely regarded as long-term investments. But along with that comes slower gains than you may experience investing in individual stocks, options, crypto or other higher-risk investments.

Remember, index funds are passively managed, so there's little chance to make quick adjustments and realize significant short-term gains.

Should You Invest in Index Funds?

As with most investments, deciding whether to invest in index funds comes down to your goals, risk tolerance level and how well a fund fits within your overall financial plan.

Investing in index funds could be beneficial if you want to diversify your portfolio and potentially earn stable returns in the long run. These funds help you access different markets across several sectors and industries, generally at a low cost.

Remember, though, matching your true personal risk tolerance to the risk of an index fund can be difficult. And since the goal of an index fund is to mimic the performance of the index it tracks, any fund you invest in could decline when the market experiences a downturn.

Investing in Your Future

If you want to invest in index funds, there are generally a few ways to do it. You can invest in your employer's retirement plan. If your company doesn't offer one, you can open an IRA and choose index funds as your investment vehicle. You can also invest in index funds through an online brokerage account.

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