With so many different ways to invest your money, it’s hard to decide what’s best for you. Index funds can be a great way to build your wealth, and passively earn money. They’re simple for beginners, they’re cheap, and they’re a relatively safe long-term investment. They sound great and all, but there’s a few things you should understand. First off, what exactly is an index fund? How do they work? And how do index funds make money?
It’s time to dig in and gain a full understanding of this seemingly wonderful product!
This article was written by our staff writer, Lindsey Smith.
What Is An Index Fund?
An index fund is a collection of stocks put together into one fund that tracks the performance, either growth or decline, of a market index. For example, a market index like the S&P 500 includes 500 of the largest publicly traded companies in the United States.
An index fund can also refer to an Exchange-Traded Fund, or ETF, which is an index fund that trades like a stock.
The price of an ETF can change during the trading day, meaning you could buy shares at 10:00 am at one price, and by 1:00 pm they could already be worth more or less than what you paid for them. This is okay though, since investing in index funds is best as a long-term strategy, where small fluctuations up and down don’t matter.
To begin to understand the question of “how do index funds make money”, we must first understand how they work.
A mutual fund, or collection of stocks, that seeks to track an index will have a portfolio that matches the assets in that index. You would then buy shares of that fund yourself. So you own shares of the fund, and the fund owns shares of those companies.
In a way, this functions like earning a percentage of the growth of that entire market. An index fund makes money by owning a share of the total market, growing your wealth over time.
So, an index fund makes you money by having the same assets as the market index it is following. You purchase shares of this fund, and as it grows, you receive dividends or capital gains.
How Do Index Funds Make Money?
There are two main ways an index fund can make you money.
- Dividends, and
- capital gains.
Both capital gains and dividends are great strategies for your long term investment goals, retiring early and growing your wealth. Though there are advantages and disadvantages to both.
The first way index funds make you money is by the value of the shares increasing over time.
This is known as long-term capital gains, the difference you make on a sale when you sell something for more than you paid for it.
When you’re using your index fund to make money in this way, the income you make is taxed much better than dividends and it grows quickly, thanks to compound growth, which we’ll talk about a little more below.
The general consensus is that it’s advantageous to focus on long-term accumulation of shares. As we know the stock market is a volatile place, so sticking it out for the long-haul makes sense.
Dividends are profits that are passed on from the company itself to its shareholders.
So if you own a share or a partial share of a company, you will get a share of the profit.
Some index funds will pay a dividend to its shareholders at various points throughout the year.
There are various elements that go into calculating dividends, such as:
- how many shares you have, and
- when you bought them.
Some companies don’t pay dividends, preferring to keep the profit in the company itself and increase the value of each share. (We’ll go into more detail about dividends below.)
Once a dividend pays out into your investment account, you often have enough to buy another share of the index fund. This, in addition to the continued growth of the fund itself, is referred to as Compound Growth.
The funds that do this for you automatically are called Accumulation Funds. The money you earned purchases you more shares, accelerating the growth. This gets much faster and more exciting down the line as your portfolio grows.
Index funds are really simple to purchase and manage. If you use a passively managed platform like Vanguard, you’ll get low fees and ease-of-use. This makes them great for beginners or people who feel like they don’t understand investing, but want to get into it.
Index funds earn money passively, meaning you park your money and it grows.
Some funds will reinvest your dividends back into the fund, helping your money grow. Plus, you’re investing in a broad market index, so rather than owning, say, one share of Apple, you can own a piece of 500 or so of the top companies in America. It removes the intensity of day-trading and gives you peace of mind while still earning a great amount.
Because it tracks a market index, it’s a fairly stable long-term investment. Since the market generally trends up, your money is likely to grow. When trading in individual stocks, there’s so much volatility and knowledge required. Index funds are hands-off investments over the long term.
What are the Disadvantages of an Index Fund?
There aren’t too many disadvantages since an index fund earns money passively, and it’s good for beginners.
One thing you should absolutely consider though is the fees that are charged.
If you are working through a financial advisor, they will take a fairly substantial fee for their services. They are actively managing your investments for you.
When investing in a mutual fund using a platform like Vanguard, your fees will be about as low as possible, since it is a client-owned company and is passively managed. For example, Vanguard has an ongoing holding fee for holding your fund of roughly 0.07%, and a platform fee of 0.15%.
Obviously, fees eat into your profit, so shopping around for low fees, ease-of-use, and a system that gives you peace of mind is critical.
They definitely can!
Some index funds pay a dividend and are legally required to pay them once per year. Of course, some funds pay once a year, some twice per year, some quarterly, and others even monthly.
Certain funds will automatically reinvest these dividends for you so you won’t ever receive a payment, which will cause your investment to grow exponentially.
Other funds, known as Income Funds, pay you the dividend on a schedule throughout the year. For example, VUSA paid out a dividend of 1.63% per year, paid out quarterly.
Not all companies pay dividends, some choose to keep the profit in the company to raise its value, thus driving up their share price.
How do you make money through dividends?
The index fund will collect all the dividends that the companies inside the fund have paid out. They then figure out how many shares you own, when you bought the shares, and pay it out to you from the index fund itself.
Different companies have different dividend policies. They control how much and when the company pays out dividends.
As we’ve discussed, some decide not to altogether. Other companies are so large it’s much more difficult for them to expand any further. They usually pass their profits along to their shareholders as dividends. The shares of these companies are considered dividend-paying stock.
According to Investopedia, the S&P 500 index has earned an average of between 10%-11% since its inception in 1926 (that’s right, before the Great Depression)!
Some years, the investment may lose money, while other years have shown gains of 30% or more! The best policy has always been, and will always be, to invest for the long haul.
The key with an index fund is that it tracks the growth of the entire market, which generally always grows. As long as you keep your money in it, you will almost certainly earn a profit.
Different mutual funds pay different amounts of dividends, so depending on your investment goals, you can shop around for higher yield or lower yield.
How Do Index Funds Make Money? The Takeaway
How do index funds make money?
- Index Funds make money by tracking a market index and matching the assets in that market.
- They passively collect dividends and pay them out on a set schedule, or reinvest them into the fund on your behalf.
- Over the long term they tend to trend upwards and are a great way to collect passive income and build your wealth.
It really is that simple. Index funds often earn a great return and they’re cheap to invest in (since there’s very little management needed).
So what do you think? Are you ready to invest in index funds?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.