What Is an Index Fund? And What Is a Bond?
An index fund does not pick and choose its investments, but instead holds all of the stocks or bonds on an index.
So what’s an index? Basically, it is a list of investments. For example, the S&P 500 is a roster of the 500 largest U.S. companies with publicly traded shares. Each stock’s weight on the list is usually determined by its overall market value. For example, in early 2014, tech giant Apple Inc. counted for about 3% of the S&P 500, whereas Avon Products was less than .05%. Likewise, an S&P 500 index fund would hold 3% in Apple and .05% in Avon.
Why choose an index fund? After they charge their annual management fees of roughly 1%, most fund managers can’t beat their fund’s benchmark index over a long period. Index funds, on the other hand, usually carry very low fees (often less than 0.2% per year) and reliably deliver the market’s average performance. In other words, by aiming for mediocrity, you in fact give yourself a good chance of beating most other investors.
Do some active funds beat index funds? Absolutely. The trouble is, it is very hard to predict in advance which funds will be those top performers.
What Is a Bond?
When you purchase a bond, you effectively are lending a company or a government money. The bond issuer is the borrower. It agrees to pay whoever holds the bond interest on a regular basis, and then to return the principal on the loan when the bond matures. This can make bonds attractive for people looking for a relatively stable investment.
“Unlike a stock where you’re not sure of future cash flows of the company, with bonds you know exactly what they’re going to be,” says advisor Rick Ferri of Portfolio Solutions. “The only risk is that the issuer ends up defaulting and doesn’t pay the debt.” The flip side of bonds’ low risk is that they have less potential than stocks for high returns.
The rate of interest a bond must pay depends in part on the creditworthiness of the buyer. That’s why U.S. Treasury securities typically carry the lowest yields in the bond market. Large, stable corporations pay a slightly higher rate. Bonds from companies with very poor credit ratings are known as junk or high-yield bonds. Junk bonds pay high rates to compensate for the risk that they will default.
Another variable key is a bond’s maturity date. That’s when the bond pays back its principal. Generally, the farther away the maturity date, the higher the interest a bond must pay.
Except in cases of default, investors know exactly what they can expect to make on a bond so long as they hold it to maturity. But bonds can also be bought or sold on the bond market, which means a bond’s current value if you decided to sell it can fluctuate. When interest rates rise, for example, the value of existing bonds on the market will fall. To understand why this is, imagine you hold a 2% bond and rates rise to 2.5%. With a 2.5% yield now available on the market, no one will want to buy your paltry 2% bond, unless you cut the price. Likewise, bond prices rise when interest rates fall.
If you own bonds through a mutual fund, you don’t have the option of waiting until the bonds in the portfolio mature. You own a constantly changing mix of bonds, so the total return of the fund is determined partly by the daily value of those bonds on the market.