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A broad-based index fund tracks a broad market index, such as the S&P 500. Index funds are considered passive investments and offer investors greater diversification and lower risk than individual stocks.
Here’s how broad-based index funds work, some examples, the advantages and disadvantages of investing in them and how to add them to your portfolio.
How do broad-based index funds work?
Index funds can be in the form of mutual funds or exchange-traded funds (ETFs). Fund managers aim to replicate the performance of the index by constructing a fund that closely resembles it, without actively managing the fund. The index fund simply tracks an index without the fund manager trying to beat the market. Broad market index funds closely follow popular indexes like the S&P 500, Dow Jones Industrial Average and Nasdaq Composite.
Index funds aim to replicate the overall performance of the market by purchasing and holding stocks from companies listed on the selected index. They have lower fees compared to actively managed funds, which gives them an advantage over the long run. Actively managed funds are more expensive because fund managers are hired to buy stocks within the same index but are always looking for and trading to get performance that beats the market.
Finally, while index funds are well-diversified, they can still underperform and lose money.
For most investors looking at the long-term — in other words, for retirement —broad-based index funds represent the best opportunity to get exposure to the breadth of the stock market. A fund based on the S&P 500 index can be a good place to begin depending on any number of different factors, including risk tolerance and investment time horizon.
— MARK HAMRICK | BANKRATE SENIOR ECONOMIC ANALYST
Examples of broad-based index funds
Here are some examples of broad-based index funds.
- Vanguard S&P 500 ETF (VOO)
- The ETF replicates the performance of the S&P 500 index, thereby providing exposure to large American companies in major industries.
- iShares Core S&P 500 ETF (IVV)
- This ETF also tracks the S&P 500 index and holds a diversified portfolio of securities in the largest U.S. companies.
- Shelton NASDAQ-100 Index Direct (NASDX)
- This fund seeks to replicate the performance of the Nasdaq-100 index and is composed of companies that operate in different industries such as biotechnology, retail and technology.
- Vanguard Total Stock Market ETF (VTI)
- This fund tracks the total U.S. equity market and invests in about 3,500 mid and small companies in addition to the S&P 500 companies.
- SPDR Dow Jones Industrial Average ETF Trust (DIA)
- This ETF replicates the performance of the Dow Jones Industrial Average index, which consists of 30 stocks of blue-chip companies that represent all sectors in the U.S except transportation and utilities.
Advantages of broad-based index funds
Here are some of the benefits of including index funds in your portfolio.
- Low fees: Index funds generally have lower fees compared to actively managed funds.
- Lower turnover: Index funds have low turnover, meaning they don’t require frequent buying and selling of assets, which helps minimize turnover costs and fees.
- Diversification: Broad market index funds allow investors to spread their risk across a variety of companies and industries.
- Passive management: Index funds are passively managed which can lead to lower expenses and better tax efficiency.
- Lower risk: Compared to owning individual stocks, index funds are considered lower risk because they provide exposure to a number of companies in the same sector, industry, or market capitalization rather than relying on the performance of a single company.
Disadvantages of broad-based index funds
While index funds have plenty of advantages, there are a few drawbacks to consider.
- Lack of adaptability: Because they follow indexes, broad-based index funds lack adaptability. For example, in the event of a market downturn, the funds will continue to follow indexes rather than change to a different tactic, which can hurt performance if the market continues to plummet.
- No control over index composition: The fund will follow the composition of the index which means if a company is added or dropped from the index, the fund will follow.
- Generally no short-term gains: Index funds are not built to capture short-term gains, so if you’re looking for that type of growth, index funds are likely not for you.
How to invest in broad-based index funds
To invest in broad-based index funds, you’ll need a brokerage account or a retirement account in which you can direct your investments, such as a self-managed IRA. If you already have an account, your next step is researching broad-based index funds to find those that match your goals and time horizon. Take a look at the management fees and the fund’s performance. When you’re ready to invest, you can purchase shares through one of your accounts or through a broker.
“While investors might want to try to make their investments more complicated than they need to be, one of the world’s most successful and wealthy investors, Warren Buffett, is a fan of exposure to the S&P 500 through index funds,” says Mark Hamrick, Bankrate Senior Economic Analyst. “His is a pretty good example to follow. Of course, his own broader portfolio has much greater scale and diversification. But for most mere mortals who are investing, such broad-based index funds can certainly serve as the backbone of a portfolio, particularly when aligned with retirement savings.”
Bottom line
Broad-based index funds are a form of passive investing that provide access to a diversified portfolio of stocks, bonds and other asset classes. They offer the potential for long-term returns with lower fees and volatility than investing in individual stocks. While they are not without their drawbacks as is with any investment, broad-based index funds offer an attractive entry point for investors of all levels.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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