TheStreet

Investors are always looking for a more efficient (and more inexpensive) way to invest in the financial markets, and on that front, index fronts have edged their way to the front of the line.

Certainly, index funds aren't perfect - no investment vehicle ever is - but the fund category has a lot going for it.

Lower funds, access to top-of-the-line global companies, and a relatively easy way to follow index funds by monitoring the market index the fund tracks, are all part of the index fund experience.

Index funds have their deficiencies, too. Higher fees, lack of investment flexibility inside the fund, a lack of downside stock market protection, and the vulnerability of one large-cap company taking down the entire funds are all concerns to fund investors.

What Is an Index Fund?

Index funds are an extension of the mutual fund family, with key variables in play.

Index funds are more similar to exchange-traded funds - both are built to mirror actual stock and bond market indices, like the S&P 500, the Russell 2000 or the Barclays Capital Long U.S. Treasury Index.

By definition, an index fund invests in the same securities that comprise a specific index. For example, an S&P 500 index-based fund is likely to include stocks like Apple  (AAPL) , CVS Corp. (CVS)  and Goldman Sachs Group (GS)  - all of which are S&P 500 index components.

Performance-wise, an index fund will closely track the performance of its underlying index, as it's comprised of many of the same securities of that index.

When an index, like the S&P 500, rises 10% in value, there's a strong likelihood (but no guarantee) that the index fund will also rise 10% in total value. If an index falls by 10%, the index fund is highly likely (but not guaranteed) to fall by approximately the same percentage rate.

History of Index Funds

Index funds remain wildly popular with Main Street investors, with index funds and their category sibling exchange-traded funds growing by an organic growth rate of 16.2% over the past decade, compared to just over 2% for traditional, active mutual funds.

While index funds have come a long way over the past two decades, their history dates back to the origins of modern portfolio theory and the birth of the Vanguard index fund, in the mid-1970s.

Index funds have long been linked to modern portfolio theory, which is based in the theorem that all financial markets are efficient, and that a stock's price holds all the information an investor needs to make a wise investment decision, and to profit from it.

That's in direct contrast to active investment management, which presupposes that financial markets are often inefficient, and thus the need for an experienced, steady professional Wall Street-savvy fund manager on hand to make the right investment decisions.

Vanguard, and its legendary founder Jack Bogle, set out to prove that theory wrong in 1976, with the rollout of the Vanguard 500 (VFINX)  Fund, the world's first index fund.

The new fund was dubbed as "Bogle's Folly" by industry insiders, who viewed the strategy of hands-off, market-tracking passive investing as a surefire loser. In the last 40-plus years, Bogle has had the last laugh.

As of November 30, VFINX has over $441 billion in total net assets, while the number of U.S.-based stock and bond index funds has risen to 290 2018. Meanwhile, the number of U.S.-based passive exchange-traded funds stood at 90, with $2.3 trillion in assets.

There's no doubt that index funds are here to stay and are a major threat to traditional mutual funds.

Pros of Index Funds

As fast as index funds are growing, there are decided advantages and disadvantages to index funds that investors should weigh before making any long-term investment decisions.

1. Low Fees

Traditional mutual funds tend to invest outside the strict boundaries of single market indexes, and as actively-managed investment vehicles, come with higher management fees than index funds.

That fee difference is important to index funds investors, who regularly cite lower fees as a big reason they invest in index funds in the first place.

How low do index fund fees go? Fairly low, as index fund fees commonly clock in as low as 0.05%-to-0.07%, compared to traditional mutual funds, which tend to charge fees in the 1.50% to 2.00% of total assets.

2. Diversified Investment Strategy

Index funds also offer investors a good dose of diversity, as many mutual funds do. Instead of purchasing an individual stock, and taking the risk that the stock will decline substantially and damage your investment portfolio, investing in an index fund offers widespread access to individual companies bundled together into one fund.

That broad exposure reduces the odds of a single stock taking down an entire portfolio, and at a low entry price, and with bargain-basement fees.

3. Set It and Forget It

When you invest in an index fund, there are no high maintenance moves to make for fund investors. For an investor looking for an affordable, efficient and direct way to access a bundle of companies, index funds don't require an investor to trade or to track the index every day.

Once a stock or a bond moves into a market index, it's usually there for a long time. When a stock or a bond is removed and replaced from an index, the index fund provider will let you know when that happens, and what security is replacing the one that is departing the index.

Cons of Index Funds

Index funds have some drawbacks that investors should know before cutting any checks to fund companies. Focus on the disadvantages first.

1. Index Funds Aren't Really Exchange-Traded Funds

While index funds and exchange-traded funds come from the same investment fund heritage, both are different, and in ways that should matter to Main Street investors.

For example, ETFs are traded on major stock exchanges with no minimum purchase. That's not the case with index funds, which often require going through a mutual fund broker, and may require a minimum purchase amount, often as high as $2,500 or $3,000.

Unlike, exchange-traded funds, which trade freely on open markets, index fund investors may find it difficult to sell assets quickly, as the sale may require giving advance notice to the fund.

Consequently, if you're in a rapidly declining market, and you want out of an index fund immediately, that may not be possible with the "advance notice" requirement that comes with index funds.

2. Low Flexibility

As index funds are passively managed, and squarely track the indexes they follow, investors may feel like they're in a straitjacket in times of market crisis. In a market downfall, active managers have more flexibility than passive managers in curbing a fund's decline during the downfall.

For example, an active fund manager can deploy hedging strategies ahead of time to protect against a market freefall, or steer fund assets to cash to better ride out the storm. Index fund managers may not have such flexibility, and fund investors may have to ride out a steep market roller coaster ride with minimum downside protection.

3. Limits on Outperforming the Broader Market

As index funds are constructed to follow specific indexes, they're usually only going to perform as well as the underlying index. In general, that's okay - you're only going to gain or lose as much as the underlying index gain or lose in the financial markets.

That said, you're also likely not to have any out-sized market gains, either. By limiting investment gains (and losses) to the general performance of the underlying index, an index fund investor is also reducing his or her chances of outperforming the market, if their portfolio is limited to index funds only.

By only tracking - and not exceeding - an index, opportunities for huge market gains outside of an index's performance are taken off the table.

Tips on Investing in Index Funds

If you're sold on the idea of index funds, make sure you know what you're doing when you dive into the market. Take these tips with you before committing to an index fund purchase:

1. Know What to Look for in a Fund

Before you buy, examine a mutual fund company's fund selection, see if they're commission-free or not, and check to see if there are any specific trading fees that can add to your investment costs.

2. Start Studying Indexes

What market indexes intrigue you the most, and represent the best bang for your buck? A good financial adviser can help here. But in general, if you like the relative stability of large-cap stocks, an index fund that tracks the Dow Jones 30 Index could be for you.

Or, if you're into growth, getting into an index, like the Russell 2000 Index, that tracks smaller, emerging companies, could fit the bill.

3. Check to See if There Is a Minimum Entry Purchase Amount

Don't be surprised if you have to spend a minimum amount, often several thousand dollars, to buy into an index fund. Not all index funds have this requirement, but many do, and you should know the entry costs before you sign on the dotted line.

Do Your Homework and Develop a Strategy with Index Funds

Index funds can be an efficient, effective, and relatively easy way to gain access to some of the highest-performing companies in the world.

Yet index funds do have limitations and even some warning signs - and it's up to you to know that those signs are, and how to react to them, if you're going to be a successful index fund investor.