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What Are Index Funds and Should I Invest In Them?

Updated: Aug 5


Back in school, whenever we studied a sentence and definitions, we were taught to break down the sentence structure and define the words. So let’s start with the word “Fund”. A fund is generally an investment made up of pooled resources with a common goal. An “Index” is a way to slice up and define all possible investments by a common thread. For example, the Standard & Poors 500 (S&P 500) is representative of the 500 largest companies in the US at a given period of time. So an “Index Fund” is simply a pooled investment vehicle that seeks to closely replicate the performance of an index. By holding an S&P 500 index fund, you would in theory own a piece of all 500 companies represented in that index.


There are two common vehicles for saving in an index fund, mutual funds and exchange traded funds (ETFs). In a mutual fund, there is a mutual fund manager that is purchasing every stock that is contained in that index and selling the ones that fall out of the index. Because there is buying and selling, there are taxes that are passed on to the investors. In the ETF, on the other hand, there is no manager, just the index. There is not any selling that occurs inside of it, so the taxes predominately occur when you sell it.


There are many different indexes, including indexes that represent a sector of the economy such as oil and gas or biotechnology, and then there are indexes that international markets, world markets, and many others. How does this differ from a non-indexed mutual fund?


A non-indexed mutual fund is also a pooled investment; however, the difference is that the mutual fund manager is tasked in choosing and eliminating companies based on their research and objectives. For example, a mutual fund might be looking at large US companies just like a S&P500 index fund would, but that mutual fund might only hold 100 companies instead of all 500 because they think those will be the best performing of the group.


So if all of these options allow you to be invested in a diversified manner, what are the main differences? First, when it comes to index funds, it is designed to closely track the index performance. With a mutual fund you have the ability to over or under perform, unlike an index fund. Next, there is a difference between investing in an ETF versus a mutual fund when it comes to the type of the account - I.e., if you have a trust account or brokerage account vs. in an IRA or 401k. The reason why is taxes. An ETF can be traded in a way that provides deductible losses on your taxes or controlled gains that mutual funds cannot.


Here’s the great thing about choosing mutual funds, index funds, and ETFs – you don’t have to. You can invest in all of them! The best options for your situation might be to use one kind in one account, and another kind in a different account. Know the differences and have someone walking with you who can explain some of the finer points.




The information contained in this communication does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Andrew Cremé and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance Every type of investment, including mutual funds, involves risk. Changing market conditions can create fluctuations in the value of a mutual fund investment. In addition, there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly.

ETF shareholders should be aware that the general level of stock or bond prices may decline, thus affecting the value of an exchange-traded fund. Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the funds may not be able to exactly replicate the performance of the indexes because of fund expenses and other factors. Investors should consider the investment objectives, risks, charges and expenses of an investment company carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional.

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