Definition and Examples of Broad Market Index Funds
What are Broad Market Index Funds?
A broad market index fund is a mutual fund that contains investments that track a large index. If you are investing on your own or working with an advisor who may have suggested one of these funds to you, it’s helpful to learn how these funds work and what they are trying to achieve.
How do Broad Market Index Funds Work?
Broad market index funds invest in a large slice of the investment market. These funds primarily track the securities listed in one of the many indexes. Some common indexes that funds track are the Standard & Poor’s 500, the Dow Jones Industrial Average, and the Nasdaq Composite.
Note: There are about 5,000 indexes in the United States. Some, like the Wilshire 5000 and the Russell 3000, track thousands of publicly-owned companies and their stocks.
Market exposure is a term used to describe the amount of money invested in a particular sector. If an investor has broad market exposure, it means they are investing in a large number of sectors. Investing across only a few sectors is one of the strategies people use to create a diversified fund and reduce risk.
Funds that provide the highest market exposure to investors are often referred to as total market index funds. A mutual fund or exchange-traded fund that tracks the Standard & Poor’s 500 is a widely diversified fund. A fund that tracks is not broad enough to be considered 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 publicly traded U.S. stocks on stock exchanges. This wide array of assets is why you see fund names that contain “total market.” One of these funds is the Vanguard Total Stock Market Fund.
Broad market index funds that invest in bonds often track the Bloomberg Barclays U.S. Aggregate Bond Index. It consists of about 8,000 bonds, hence the name “aggregate bond index” for those funds that track it.
Advantages and Disadvantages of Broad Market Index Funds
Advantages
Broad market index funds have the same advantages provided by other index funds, along with some additional benefits. Here are the main benefits for investors:
1. Low fees: Like most other index funds, broad market index funds have an expense ratio of less than 0.20%, which is $20 for every $10,000 invested. Low costs help increase returns, especially over the long term, because lower fees mean more money compounded over time.
2. Low turnover: One of the main reasons for the low fees and costs of index funds is that the assets aren’t sold and replaced at a high rate. When this happens, it’s referred to as “turnover.” Actively managed funds (not index funds) can have turnover ratios greater than 50%, but index funds typically have less than 5%.
3. Greater diversification: Most index funds are diversified, meaning they invest in a large number of securities. Broad market index funds offer even greater diversification, meaning they invest in more securities than narrower index funds.
4. Passive management: Broad market index funds are passively managed, meaning the manager does not actively try to outperform the benchmark index. Instead, they aim to closely track the performance of the benchmark index, whether it does well or poorly. This approach reduces some risk for investors.
5. Tax efficiency: Low turnover reduces the taxes that investors face. When mutual funds sell assets at a higher price than what they paid, a capital gain is realized. Capital gains lead to capital gains taxes. Low turnover helps avoid extra taxes from high turnover.
Disadvantages
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Because broad market index funds are similar to index funds, they have many of the same drawbacks:
1. Limited flexibility: Fund managers follow the fund’s directives, which results in less flexibility compared to an actively managed mutual fund. When investing in a broad market index fund, your money is locked into investments that the manager must track. Because of this, if prices start to decline, you’ll have to continue investing and hope for the best.
2. Modest gains: Due to their diversified nature, broad index funds tend to be neither the best nor the worst when compared to other more narrow and sector-focused funds.
3. Cannot outperform the indices: The returns on managed index funds typically lag behind their benchmark indices most of the time.
Key Takeaways
Broad market index funds provide investors with wide market exposure. They come with benefits such as lower risk and low costs for investors. However, broad market index funds are less flexible than mutual funds or other actively managed funds.
Source: https://www.thebalancemoney.com/investing-in-broad-market-index-funds-4153405
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