Index funds can be a low-cost, low-risk way for investors, especially first-timers, to get into the market. But what exactly are they?

What is Index Fund?

You can think of an index fund as a basket of stocks with hundreds or thousands of different ones inside, explains Nick Holeman, a certified financial planner at Betterment. For example, the S&P 500, is a fund that holds stocks for the 500 largest companies in the U.S., which includes familiar brands such as Apple, Google, Exxon and Johnson & Johnson.

“It’s the cheapest and easiest way to diversify your money that you’re investing,” Holeman says.

“Think of it this way: If every individual stock is a Lego brick, buying an index would be like getting a set of Legos that includes one of every colour. Instead of saying, ‘I want this piece and this piece and this piece,’ you’re getting every big piece that’s out there,” explains Andy Smith, a CFP at Financial Engines.

The rate of return for each index fund is determined by the performance of the companies that are in it, which can balance each other out. For example, if you purchase an index that contains only two companies, if one goes up by 3%, but the other goes down by 2%, you’re still up by 1% overall.

That’s partly why index funds are considered a form of passive investing. “Instead of you and your analyst team identifying which stock you want to buy and when you want to buy it and when you want to sell it, you say, ‘No, we’re going to buy exactly what’s in the index and weighted for in that particular index,'” Smith says. “You’re not making any decisions, you’re just buying the index as it’s there in front of you.”

Benefits of Index Investing

Index investing is low-cost because they don’t require a portfolio manager who needs to be paid. You are basically purchasing an index that tracks the performance of the market instead of buying and selling shares in particular companies.

Similarly, index funds are tax efficient because they don’t require much trading. Managers are “not constantly buying and selling within that fund,” Holeman tells CNBC Make It. “Anytime that you do a lot of buying and selling, there’s the potential to cost yourself a lot in taxes.”

“For consumers, that can translate to more money in your pocket. Because you aren’t paying an advisor as much as you would for actively managed funds, you’re probably saving money in fees that could cut into your returns,” Holeman says.

Warren Buffett agrees, “Costs really matter in investments,” he says. “If returns are going to be 7% or 8% and you’re paying 1% for fees, that makes an enormous difference in how much money you’re going to have in retirement.”

Buffett is a proponent of index funds as a way to boost long-term investments, such as retirement savings. “Consistently buy an S&P 500 low-cost index fund,” he told CNBC’s On The Money. “I think it’s the thing that makes the most sense practically all of the time.”

“The trick is not to pick the right company,” Buffett says. “The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.”

Another major benefit of index investing is diversification. Diversification is one of those fancy investing words, but all it really means is spreading your money out into lots of different types of investments instead of putting all your eggs in just a few baskets.

For example, instead of buying just a few stocks, you can diversify by buying stock in every single company in the US. By doing so, you’ve removed the risk of any single company sinking your investment portfolio.

In fact, diversification is often called the only “free lunch” in investing because it’s the only way to decrease your investment risk without decreasing your expected return. With that kind of benefit, why wouldn’t you take advantage of it?

Because index funds invest in entire markets, they are a great way to get the diversification you’re looking for.

Lastly, index investing makes it relatively easy to stay consistent. When all you’re doing is picking a few different funds to track a few different markets, there simply isn’t all that much to tinker with. And the index funds themselves will keep tracking the same markets, so there’s no risk that some manager will suddenly decide to do something different, forcing you to rethink all your investments.

Investing in NEBA’s Structured Products

At NEBA Financial Solutions, we issue a variety of index-linked structured products on a weekly basis. There is an infinite amount of combinations that index investors can pick and choose for their portfolios with NEBA’s structured notes. Click here to view the range of products currently open for investment.

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