Charles Schwab explains how index funds can help you build a diversified portfolio.

What Are Index Funds

Opens in popupRead transcriptfor What Are Index Funds

Charles Schwab
Chairman of the Board and Founder, Charles Schwab & Co., Inc.

"It's a very simple decision; 'Do I have enough money each month to put aside and where should I put it?' My recommendation is to put it in index funds, particularly as a younger starting investor. 

One of the great features of index funds and broad based ETFs is that you get the advantage of broad diversification, you get many stocks. 

So if you...let's say invest in an index fund or some with S&P 500 there'd be 500 companies, they represent about 70% of American's value of stocks, we have a fund called the Schwab 1000, it's 1,000 stocks, represents about 85% of the companies value in the United States. That is, of course, very broad diversification. And so if there's one industry that goes up, oil for instance, and another going down, utilities going down, you have an investment in every major sector of the economy."

Text: What is an Index Fund? 

Voice over: "In the first video in this series, we looked at the importance of looking at stocks to grow your wealth. But choosing the companies and industries that will deliver the best earnings growth is a real challenge.

Competitive trends, management's ability to execute on their plans, and unpredictable events make it very hard to forecast results with success and consistency. 

Most people just don't have the interest, time or expertise to pick individual stocks well. Multiply that effort by the many individual stocks you'll likely need for a well-rounded portfolio and the complexity adds up quickly. 

Research shows how difficult it is, even for the pros, to actively buy and sell individual securities and match the market. So to get the best chances for building a portfolio that is designed to grow and to get invested in as many different companies in as many different sectors as you need to be well diversified, what do you do?

One of the easiest and low cost ways to get invested in as many companies as possible is to invest in a mutual fund or an Exchange Traded Fund (an ETF) to own a basket of companies. And a smart approach to that is index investing which provides two important advantages: Diversification and minimizing costs.

You're probably already familiar with indexes such as the S&P 500, the Dow Jones or the NASDAQ. In fact, when people talk about the stock market, they're usually thinking about an index. And while you can't invest directly in an index, many mutual funds and ETFs track these indexes simply holding the same stocks in the same proportion as are in the index. 

Index funds can give you broad exposure to the market. Some are so broad in fact, that buying them means you own a tiny piece of almost every public company in America with just one investment.

Index investing can be a useful tool for both experienced and in-experienced investors to form the core of a well-diversified portfolio." 

Text: What will it cost?

Voice over: "When it comes to investing, controlling costs is important. In fact, it's one of the few things you can control. Index funds are typically low cost compared to either buying stocks individually, where you pay a commission for each purchase or sale, or investing in managed funds, which pay managers to choose stocks and make trades. 

And with the advent of ETFs costs drop dramatically. Now you can get access to the entire US Broad Stock Market for an annual fee of .03%. That means that on a $10,000 investment, you would pay a fee of $3 a year to own about 2,000 stocks. Lower costs means more money stays working in your portfolio and over time this can have a big impact on your outcome. 

Charles Schwab: "To me there's lots of confusion in a discussion about investing and you want to make it simple. Some parts of the industry make it too complicated. Look for the firms, look for people who make it simple for you."

Close

What is an index fund?

It's a fund that tracks a specific market index. The goal: mirror the index's holdings, activity, and return.

  • They don't require a fund manager to actively select investments; instead, the vehicle buys a broad representation (or all) of the securities in an index.
  • They are generally more tax-efficient than actively managed mutual funds because there's less buying and selling of the fund's securities.
  • They generally have lower costs.
     

Use our tools to find the right index fund for you.

Explore Mutual Funds

What are some popular market indexes?

  • Dow Jones Industrial Average

    Consisting of 30 companies, "The Dow," as its usually called, is often quoted as a barometer of market performance. Most companies are listed on the New York Stock Exchange, but a few are on the Nasdaq Exchange.

  • S&P 500®

    Short for the "Standard & Poor 500," this index contains 500 of the largest U.S. companies, which are selected by a committee. It's generally considered to be a better market indicator than the "Dow" because of its coverage and market-cap methodology.

  • Nasdaq Composite

    This index consists of all the common stocks traded on the Nasdaq Exchange. Most are technology and internet-related, but there are financial, consumer, and biotech companies too. 

  • Schwab 1000®

    This index tracks 1,000 of the largest publicly traded U.S. companies, offering investors exposure to 90% of the total U.S. stock market. It's designed to capture the growth of both large and mid-sized companies.

What types of index funds are there?

  • Traditional (or market-cap) index funds

    This is a popular type of fund that tracks indexes weighting companies based on the market value of their stock or debt—its "market capitalization." Most major market indexes follow this approach.

  • Fundamental (or factor ) index funds

    While also index-based, these funds break the link with price (size) and, instead, weight holdings based on a variety of economic factors. These factors, called fundamental measures, can include a company's adjusted sales, cash flow, dividends, and stock buybacks.

Find low-cost funds that track a specific index.

View Our Index Funds

What are the pros and cons of index funds?

  • Pros

    Cost-effective
    They generally have lower management fees.

     

    Tax-efficient
    Index funds don't change their holdings as often as actively managed funds, typically resulting in fewer taxable capital gains distributions. 

     

  • Cons

    No control over the holdings
    These funds provide access to a wide variety of investable markets; however, an index fund might not include a company you like or believe will perform well as they are focused on broad market access. 

     

    No downside protection
    While funds tracking indexes such as the S&P 500® have proven to be relatively sound long-term investments, investing in such an index fund means you're still subject to market performance, even when markets fall. 
     

     

What are other factors to consider when choosing an index fund?

All index funds aren't created equal. It pays to take a closer look.

  • Strategy

    Which asset class does the fund provide exposure to? Is the index methodology clear and sensible?  For example, how does the index select and weight securities? How often does the fund rebalance the securities in its portfolio?

  • Performance relative to benchmark

    How has the fund performed relative to its benchmark, and in absolute terms? And not just at one year, but three, five, and 10 years? Has the fund tracked the same index over its entire life? 

  • Fees and costs

    What is the fund's operating expense ratio Tooltip ? Does the fund charge you to buy or sell its shares? What share classes does it offer?

Next steps

  • Explore mutual funds at Schwab.

    Find 4,000+ no-load, no transaction fee mutual funds from Schwab and others.

  • Choose mutual funds with our help.

    Get the expertise to build a strong mutual fund portfolio on your terms.

  • Simplify with our all-in-one solutions.

    Choose the fund according to your investing goal, then we do the rest.

Ready to start investing?

Need help understanding your mutual fund options?