Learn what broad market index funds are, how fund managers design them, and some pros and cons they offer.
What Are Broad Market Index Funds?
An index fund is a basket of investments, such as stocks and bonds, that allows a person to purchase a few investment types in one sale. The managers of the fund disburse the invested money per the fund’s guidelines. They passively manage the fund and only make changes to the portfolio when there’s a change in the larger index being tracked.
How Do Broad Market Index Funds Work?
Broad market index funds invest in a large segment of the investment market. These funds mostly track securities listed on one of the many indexes. Some of the common indexes that funds follow are the Standard & Poor’s 500, the Dow Jones Industrial Average, and the Nasdaq Composite. Market exposure is a term used to describe how much money is invested in a sector. If an investor has a broad market exposure, it means they invest in a good amount of sectors. Investing across a handful of sectors is one method people use to create a diverse fund and reduce risk. The funds that offer the broadest market exposure to investors are often called total market index funds. A mutual fund or exchange-traded fund (ETF) that tracks the S&P 500 Index is a broadly diversified index fund. A fund that follows it is not broad enough to be looked at as a broad index fund. Broad market funds invest in a larger index, such as the Wilshire 5000 or Russell 3000. The Wilshire 5000 and Russell 3000 include most of the U.S. stocks traded on stock exchanges. This wide group of holdings is why you’ll see fund names with “total market” added. One such fund is the Vanguard Total Market Index Fund Admiral Shares. Broad market index funds that invest in bonds often track Bloomberg Barclay’s U.S. Aggregate Bond Index. It consists of about 8,000 bonds, hence the name “total bond index” for those index funds that track it.
Pros and Cons of Broad Market Index Funds
Pros Explained
Broad market index funds have the same advantages that other index funds offer, with a few extra. Here are the primary benefits for investors.
Low Expenses
Like most other index funds, broad market index funds have expense ratios lower than 0.20%, which is $20 for every $10,000 invested. Low costs help boost returns, even more so in the long run, because fewer fees equal more money compounding over time.
Low Turnover
One of the main reasons for the low fees and costs of index funds is that the holdings are not sold and replaced at a high rate. When that happens, it is called “turnover.” Many actively managed funds (non-index funds) can have turnover higher than 50%, but index funds usually turnover less than 5%.
Broader Diversification
Most index funds are diversified, meaning that they invest in a large number of securities. Broad market index funds offer greater diversity, meaning that they invest in a larger number of securities than narrower index funds.
Passive Management
Like other index funds, broad market index funds are passively managed, which means that the manager is not actively trying to beat the benchmark index. Instead, they are trying to track how well or badly the benchmark index performs. This action removes some risk for investors.
Tax Efficiency
Low turnover lowers taxes passed through to the investor. When mutual funds sell holdings at a price higher than the purchase price, capital gains are made. Capital gains trigger capital gains taxes. Less turnover prevents extra taxes caused by higher turnover.
Cons Explained
Since broad market funds are similar to index funds, they have many of the same disadvantages.
Lack of Flexibility
Fund managers follow the fund’s guidelines, so they end up with less flexibility than an actively managed mutual fund might have. Buying into a broad market index fund locks your money into the investments the manager is required to track. Because of this, if prices start to fall, you’ll have to ride it out and hope for the best.
Modest Gains
Due to its diversified nature, a broad index fund will typically be neither the best performer nor the worst when compared to other, more narrow funds and sector-focused funds.
They Can’t Beat the Indexes
Returns on passively managed index funds trail their underlying indexes most of the time.
