It is a simple question with a complicated answer: are index funds better than stocks? This is completely up to your risk tolerance and investing style.
Both asset classes have distinct advantages and disadvantages. One can argue that both deserve to be a part of any well-diversified investment portfolio.
Before we can dive deeper, it will help to know exactly what an index fund is and how they work. There are some common misconceptions surrounding index funds in today’s market.
These biases are often misinformed and could be clouding your long-term investment objectives. Index funds can often have high expense ratios that eat into investors’ returns over time.
This can lead to lower rates of long-term returns compared to investing in stocks. The problem with this logic is, you have to pick the right stocks in the first place. When you consider all these factors, you’ll see why some investors would prefer to own individual stocks instead.
So here is a closer look at one of the more misunderstood asset classes in the financial world.
What is an Index Fund?
An index fund is a passively managed fund that tracks a particular index on the stock market. These are a specific type of mutual fund or exchange-traded fund (ETF). They provide investors exposure to all the individual stocks that belong to the same index.
Index funds track a large-cap index like the DIA or the S&P 500 index.
Index funds are usually an alternative to actively managed funds. Contrary to popular belief they can co-exist with actively managed funds in any investment portfolio.
This is part of the beauty of them: index funds work the same way no matter what the rest of your portfolio has in it. Index Funds can be your primary or secondary asset class in your brokerage account. They add stability to your portfolio.
There are several immediate benefits to buying index funds. These include lower expense ratios, lower volatility, and broad market exposure to a large group of individual stocks. Index investing removes the need for a fund manager.
Index mutual funds and ETFs are simple and are perfect for those who prefer to do passive investing.
How Do Index Funds Work?
Any mutual funds or exchange-traded funds that track a broad market index are index funds. Thus, when you buy index funds, you receive exposure to every stock that trades as a part of that index.
Let’s say you were to buy the QQQ index fund. You would be investing a small part in all 3,300 stocks that trade on that large-cap index.
The same is true if you bought shares of the SPY index fund. You would be investing a small part into all 500 companies that trade on the benchmark index.
Index funds are what investors refer to as passively managed funds or passive funds. This means that you do not need index fund managers making trades or trying to time the market for individual stocks.
Instead, the index fund tracks the performance of the market indexes that the fund is tracking. Passively managed mutual funds or exchange-traded funds also usually have lower expense ratios. These are the transaction fees that come with fund management.
Since index funds do not require fund managers, there are few, if any, trading costs to incur.
Another benefit to index funds is that there is infrequent turnover for the portfolio holdings. If we take the S&P 500 as an example, this index does stockholding rebalance at the end of each quarter. But there are also general requirements for a company to be in the benchmark index.
Here are the requirements a company needs to meet:
- Market cap of more than USD 13.1 billion
- The company must have a public float of at the minimum of 10% of its shares outstanding
- The company must be a publicly-traded company for more than one year
If we take the first point on this list, we know that the market cap of a company can be highly volatile. A company can fall below that level and then climb back above it within the same trading session. So while the major reshuffle happens near the end of each quarter, there are smaller changes that occur in the meantime.
Exchange-Traded Fund vs Mutual Fund
You might have noticed that index funds can fall into two distinct categories: Index ETFs and Index Mutual Funds. But is there a difference between the two types of funds? There is a lot of overlap between the two types of funds, but there are some key differences that set them apart as well:
Actively Managed Mutual Funds vs Passively Managed ETFs
The main difference between mutual funds and ETFs is their management. Like index funds, ETFs are generally passively managed. They tend to have lower expense ratios and fewer transaction fees than mutual funds. On the flip side, mutual funds are actively managed funds.
They usually have a fund manager that is trying to time their trades. The goal is to maximize market inefficiencies rather than simply track indexes.
Mutual Funds and ETFs Trade Differently
Mutual funds are only traded at the start or end of a trading session. You can buy or sell mutual funds at any point during the day. But the price you buy or sell them for during the following session is reliant on the market close.
This price, the NAV or net asset value, remains the same throughout the next session. Rather than buying individual shares of a mutual fund, investors can buy units of the mutual fund at the specified net asset value price.
On the other hand, ETFs trade more like individual stocks. The price of the ETF fluctuates throughout the trading session, and investors can buy shares of the ETF rather than units. You can even sell ETFs short and trade options contracts for them as well.
Some of the top index ETFs are very popular amongst options traders. This is because the day-to-day price action can be a little more predictable than an individual stock.
Expense Ratio Differences
We already covered why the expense ratio is different for mutual funds and ETFs. Having an actively managed fund will always add a higher expense ratio for investors. Passively managed index funds seek to track a broad market index with as little trading as possible.
This is exactly why we can reasonably expect to pay lower expense ratios for ETFs. A few tenths of a percentage might not seem like much, but transaction fees can add up over the years. This can eat into your long-term capital gains.
When to invest in index funds or stocks
You might be wondering what type of investors would choose stocks over an index fund at this point. Passive investing works wonders for most people. Particularly those who do not have the time to follow so many different companies daily.
Active investing can dwarf passive investing returns in the short term but does require quite a bit more work.
Why Choose an Index Fund?
They are just so easy to use! If you do not want to deal with things like asset allocation or dollar-cost averaging, then index fund investing allows you to just set it and forget it. Once you have deposited your initial minimum investment, you are free to continue adding to that amount to your heart’s content.
It doesn’t matter if you’re adding units in an index mutual fund or buying shares of an index ETF. The more you add to an index fund the more your money will work for you over time.
Why Choose Stocks?
The answer is simple. By choosing the right allocation of high-performing stocks, you can outgain the returns of any large-cap index. The S&P 500 has an average annual rate of return of 10-11%, dating back to its inception in 1926.
While that is an impressive benchmark to set, most investors can find stocks that can beat those annual returns in a given year. All it takes is a little research.
Who Should Invest in Index Funds?
Even though index funds have a role in every investment portfolio, passive investing is not for everyone. Traditionally, younger investors who have a higher risk tolerance, shy away from passive investing. They usually prefer to seek out larger gains due to their long-term horizon.
Or, older investors who are closer to retirement, seeking a steady investment will likely find index funds are safer. These investors are usually more risk-averse, not willing to put all of their eggs into one basket.
The correct answer to this question is anyone! That’s right, whether you are a brand new investor or a seasoned veteran, everyone has room for index funds in their diversified portfolio. You can be a risk-seeking options day trader. But you still have room in your portfolio for some index funds. They can act as a stable hedge to the volatile trading of options contracts.
Index Funds and Taxes
One question investors always have about different asset classes is about the tax implications. We all love making capital gains from our investments, but who enjoys paying taxes on those gains?
There are some subtle differences when it comes to paying taxes on index mutual funds versus index ETFs. This comes down to the number of capital gains made using the different trading mechanisms involved in actively managed funds and passively managed funds.
What are Capital Gains?
Before diving into tax discussions, it helps to have a refresher on what capital gains are. In its simplest definition, capital gains are the profits made from the buying and selling of an asset. When you buy a stock for $100 and sell that same stock for $110, your capital gains are $10.
In the US, we’re taxed on capital gains as a form of income. There are two different taxation rates when it comes to capital gains. The short-term capital gains rate or the long-term capital gains rate.
The short-term capital gains rate is for any capital gains made on an asset held for less than a calendar year. Subsequently, the long-term capital gains rate is for any capital gains made on an asset held for longer than a calendar year.
Index Mutual Fund Taxation
Mutual funds are generally deemed to be slightly less tax-friendly than ETFs. Why is this the case? Since mutual funds are actively managed, fund managers can usually generate a higher rate of return than a passive index fund.
There is a greater amount of transaction fees and higher expense ratios. So in the long-run, mutual funds can be less appealing for investors who have a long-term investment objective.
So why would investors choose a mutual fund over ETFs when it comes to taxes? Mutual funds can be easier to invest in, especially for ETFs that have a higher net asset value.
Most mutual funds have a minimum investment amount that investors can purchase. ETFs often require you to buy whole shares instead.
Index ETFs Taxation
ETFs have gained popularity amongst investors in recent years because they are easier to invest in and save on capital gains taxes. Since ETFs are not considered actively managed funds, they utilize a specific mechanism for trading.
Rather than having fund managers actively buying and selling stocks within the fund, ETFs use something called creation units. For the most part, this allows investors to bypass paying capital gains taxes, even though the value of the ETF has risen from the time of its purchase.
A Final Word on Index Fund Taxes
All of the above depends on investors purchasing an index mutual fund or index ETF in a normal investing account.
In the United States, investors can avoid taxes altogether when trading funds or stocks in a traditional IRA or Roth IRA account.
Make sure you are aware of the tax rules for your investment and retirement accounts and seek financial advice if you are unsure of these rules.
Disadvantages to Index Funds
As you probably know, there is no perfect type of investment or asset class. While index funds are convenient, steady investments, they have their disadvantages too. It is widely believed that most fund managers do not beat the market over time.
So why not just track the market itself? Many index funds will do just that. While it’s proven to provide a steady return over the long term, some investors are not that patient. Here are a few disadvantages to investing in index funds.
Your Holdings are Set
You can invest in an S&P 500 index fund but you have no control over which companies are in the benchmark index. This might not be a problem for most investors but some prefer to know exactly what they’re invested in.
There is a chance that these investors will not agree with some of the companies included in the index. Unfortunately, when you are index fund tracking, there is just no way around this.
The Investing Horizon is a Long One
Let’s be honest, a lot of investors simply do not have the patience or the time to wait for their index fund investment to provide high returns. We are also in an era of investor that desires higher returns in a shorter amount of time.
It is why so many new investors seek out events like a short squeeze or try to trade in options contracts without any experience in the stock market.
Nobody is retiring overnight from investing their money into an index fund, even if it is one of the top index funds on the market. Long-term investing is out of style right now, and index fund investing is the epitome of it.
Index Fund Investing Can be Boring
It’s the truth! Some investors love it because it is boring. For those who love to check the financial markets every morning and see how their stock investments are performing, index fund investing might not be for you.
You only have to check the performance of that index. You don’t have to search for ticker symbols or have a watchlist.
The performance of individual companies is mostly irrelevant. One or two stocks generally do not have any impact on the performance of the underlying index.
Most Popular Index Funds
Currently, there are thousands of different index funds to choose from. This depends on your brokerage. Depending on which index fund company you invest with, you could see lower costs for that index fund management.
Theoretically, any S&P 500 index fund should perform similarly since they are all tracking the same index. There are hundreds of different brands you can use as an index fund company or mutual fund company, so here are some of the more popular ones.
Vanguard Funds
Vanguard is now the largest provider of mutual funds in the world, with hundreds of different funds to invest in. What sets Vanguard funds apart from other fund companies is that they have some of the lowest expense ratio costs on the market.
These lower costs translate to greater success and gains for Vanguard funds, which in turn leads to more investors choosing to buy them. Vanguard has many mutual funds under its umbrella and nearly 100 different index funds to invest in.
State Street Global Advisors
State Street is another well-known fund company that provides investors with a wide range of actively managed mutual funds and ETFs. Like Vanguard funds, State Street Global Advisors also provides one of the lowest average expense ratio rates for investors.
The most popular index fund ETF that State Street Global Advisors lists are the SPDR S&P 500 index ETF.
iShares
iShares is one of the largest investment companies that offer both index mutual funds and index fund ETFs to its customers. The company offers the popular iShares core S&P 500 ETF.
They also offer dozens of other index funds that receive a high investment grade from investors and analysts alike.
iShares is also known for a lower expense ratio and is a worthy addition to any diversified brokerage account.
Best Stock Market Index to Invest in
S&P 500
The index that acts as the measuring stick for the US economy and equity market, the S&P 500 is the most tracked large-cap index in the world.
There are a surprising number of equity index funds that track the S&P 500 index. Be aware that each investment company offers its version of the benchmark fund. If you are to own one large-cap index fund in your portfolio, you can’t go wrong with the S&P 500.
The Dow Jones Industrial Average
Some believe the concept of the Dow Jones Industrial Average isn’t relevant. But, many investors believe the Dow 30 is still a relevant barometer of American industry.
There is a lot of overlap between the S&P 500, the Dow Jones, and the NASDAQ. Especially since mega-cap tech stocks have dominated the US markets for the past decade.
The blue-chip Dow Jones has a long list of index mutual funds and index ETFs that track its progress. Some investors are likely in favor of an index that only tracks 30 different companies rather than 500.
The NASDAQ
The NASDAQ is an interesting index to invest in as its asset allocation is heavily weighted towards technology stocks. This provides a higher ceiling for the index but also a much lower floor. If the NASDAQ is your target index to track, you will need a stronger stomach. High-growth tech companies are usually subject to higher levels of volatility.
Over the past five years, the NASDAQ has handily outperformed the S&P 500 and has more than doubled the return from the Dow Jones Industrial Average.
Price-Weighted Index vs Market Capitalization Weighted Index
When browsing through which market indexes to invest in, you have likely come across the fact that they are not weighted the same.
This is the main reason why the calculation of the basis points of each target index is different. Here is the difference between a price-weighted index and a market-cap-weighted index.
Price-Weighted Index: the Dow Jones Industrial Average
The Dow Jones uses a peculiar way of determining its true value: it takes the share price of each of the 30 stocks held in the index and adds them up. The weight that each stock has in the index is also determined by how high the current share price is.
In an age where we know the stock price means less to the value of a company than the market cap or other financial metrics, the price-weighted index seems archaic and oversimplified.
Market-Cap-Weighted Index: The S&P 500
Even though the price-weighted nature of the Dow Jones feels antiquated, it does not mean that the market-cap-weighted indices are any better.
With mega-cap tech companies growing their market cap to over $1 trillion, a handful of companies have a significant influence on the performance of the S&P 500.
To provide an example of the two different methods, Apple (NASDAQ: AAPL) has a more significant impact on the S&P 500 than in the Dow Jones. Apple has the largest market cap in the world but has the twelfth highest share price in the Dow 30.
Does the Type of Index Affect Index Fund Investing?
In terms of a price-weighted index compared to a market-cap-weighted index, there isn’t a quantifiable effect on the index fund’s performance.
Index investing tracks the performance of the index as a whole. Of course, if you believe in the big tech companies with the highest market caps in the world, you will likely associate more with a market-cap-weighted index.
Conclusion: Index Funds vs Stocks
In the end, the answer to this question remains entirely dependent on the individual investor. For many investors, relying on index funds is a simple and effective way to see nearly guaranteed long-term returns.
It removes the need to research individual companies and provides a bit of a safety net and hedge against market volatility.
Investing in index funds also comes with some differences in the type of asset class. When you buy individual stocks, you likely will not incur any transaction fees, especially if you trade in the United States.
But when you buy units of index mutual funds or shares of an index ETF, you are bound by built-in fees to the fund called the expense ratio.
Mutual funds come with a higher expense ratio than ETFs. This can make a difference to your return on investment over a long-term investing horizon.
Index investing can be simultaneously optimal for some investors and boring for others. But for most people, index funds present an opportunity to put your money to work without ever needing to worry about the price of an individual stock.
Perhaps the most common misconception with index investing is that when you own index funds, you only own index funds. This is simply not true at all. All investors stand to have some exposure to index funds in a fully diversified portfolio, whether you trade individual stocks or not.
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