IF YOU'RE JUST GETTING started in building a mutual-fund portfolio, buying an index fund can be one of the easiest, most effective ways to go. If the goal is long-term growth and simplicity, these no-fuss funds are a great solution.
So how do they operate? Technically, index funds do have managers, but they don't have a heck of a lot to do. They simply buy all the stocks or bonds in a chosen index with the goal of matching that group's performance. And what's an index? It's a grouping of stocks chosen to represent a certain market segment. The S&P 500 index (the index most widely tracked by index funds), for instance, consists of large-cap stocks. The Nasdaq Composite index is heavy on technology companies. And the Russell 2000 is a benchmark for small-cap companies.
Index funds have two advantages that help them deliver solid returns: tax efficiency and low expenses. Low turnover limits tax liability . And because the manager doesn't have to look actively for stocks, these funds are relatively cheap to operate and have expense ratios as low as 0.2%. In contrast, the average large-cap fund charges more than six times that much.
Keep in mind, though, that these advantages don t make index funds immune to losses. An index fund will be just about as volatile as the index it tracks. If the S&P 500 tanks 20%, so will the index funds that track it.
That said, over time, the return of this index has been decidedly positive. So while you shouldn't necessarily expect a smooth ride, we think index funds can still make up the backbone of a solid, long-term portfolio. Yes, a terrific fund manager should be able to beat the index. But most managers don't.
Bottom line? While index funds can be bumpy over the short term, we believe they're one of the best options around for long-term investors.