If you’ve been toying around with the idea of investing in an index fund (or have already done that), chances are you’re familiar with the magic of compounding. It’s an indispensable tool for growing your nest egg, whether you’re investing in an index fund or any other type of mutual fund. However, it’s not always clear how often that magic happens because different funds have different policies and underlying investments.
Interest in an index fund compounds as often as the fund receives distributions. If the fund pays out distributions once a year, interest will compound annually. Similarly, your interest will compound bi-annually if the index fund in question makes distributions twice a year.
Read on for details on how interest compounds in an index fund, how often it happens, and the factors that dictate its frequency.
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How Compound Interest Works With Index Funds?
You need to have an idea of how interest compounding works in an index fund to understand some of the things I’ll mention when explaining how frequently interest compounds in an index fund.
Index funds are investment companies and are regulated as such.
As part of compliance with the Investment Company Act of 1940, index funds are legally obligated to pay out dividends and interest earned by their holdings (net of expenses) to investors as distributions. In today’s post, we’ll be focusing on the interest part of those distributions.
When an index fund pays out interest, you, the investor, can withdraw or re-invest that money. More often than not, investors choose the latter option, and that’s where the compound interest comes in.
When you reinvest this year’s interest, your principal for next year, which is the figure they’ll use to calculate your interest, will include the reinvested interest. So next year, you’ll earn interest on the current year’s interest. That’s why compound interest is sometimes referred to as “interest on interest.”
I know this doesn’t sound very clear to some, so let’s look at an example to clear things up.
Compound Interest Example
Let’s say that you invest $10,000 in an index fund that earned a 9% interest at the end of the first year. At the end of the first year, your investment will have earned an interest of $900 (9% * $10,000).
If you reinvested the $900 interest, your investment at the end of that year would be worth $10,900. With compounding, this figure would also be the starting principal for the next year.
If the index fund provides the same 9% return in year 2 (annual returns in index funds are barely uniform; this is just for simplicity purposes), your interest for that year would be $981 ($10,900 * 9%). So now, your investment would be worth $10,900+$981=$11,881.
Notice how the second year’s interest is higher than the first year’s interest even though the rate of return remains constant? It’s because, in the second year, you earn interest on the first year’s interest.
That, in a nutshell, is the magic of compounding.
For comparison purposes, here’s a table showing the value of this hypothetical investment after ten years with and without compounding ,assuming the same 9% consistent return.
|Initial principal||Value of investment after 10 years With compounding interest.||Value of investment after 10 years Without compounding interest. (i.e., simple interest)|
Evidently, compounding results in more total accrued interest ($13,673.64) than simple interest ($9,000). And if we extrapolate these results for a longer time, this difference gets even bigger. Don’t believe me?
Just plug the numbers into this online calculator, but change the investment duration from 10 years to 20 0r 30 years.
How Frequently Does Interest Compound in an Index Fund?
Generally, interest for loans and investments can be compounded at various time intervals, such as daily, monthly, annually, semi-annually, or even continually. In index funds, however, “compounding” occurs when you reinvest your earned interest.
As such, interest compounds as often as the frequency of the fund’s distributions.
That means if an index fund makes distributions that include interest once a year, interest will compound annually. Similarly, your interest would compound semi-annually (i.e., twice a year) if the index fund makes interest distributions after every six months.
As a general rule, the more often interest compounds, the more exponentially your investment grows. So naturally, you’ll want to invest in an index fund that pays distributions as often as possible to give your money the best chance of growing through compounding.
To find such a fund, it helps to know the factors that determine the frequency of index fund distributions. Let’s review those below.
What Determines an Index Fund’s Frequency of Interest Distributions?
The most critical determinant of the frequency of distributions in an index fund is the type of securities held in its portfolio. Index funds may hold various interest-generating securities in their portfolios, including:
- Certificates of Deposits (CDs)
- Treasury bills
Since index funds are inherently diversified, they most commonly hold a combination of these interest-generating investments alongside other securities. Depending on which of the above investments your index fund holds in its portfolio, your interest may compound with a frequency that may range from weekly to annually.
For instance, bond index funds tend to pay dividends once a month.
These dividends primarily consist of interest earned on the underlying bonds. So if you reinvest dividends from a bond index fund, your interest would likely compound on a monthly basis.
Meanwhile, index funds that hold certificates of deposit may pay interest at varying intervals. Generally, CDs pay interest bi-annually or at maturity. The thing is, the maturity period may range from a few weeks to a year.
So while interest may typically be paid bi-annually, it can be anything from weekly to annually depending on the certificate of deposit’s maturity.
Similarly, REIT index funds pay out dividends, which may include interest if the underlying investments are mortgage REITs, at varying intervals. Some pay monthly, while others do so quarterly. So if you invest in a REIT index fund, your reinvested interest may compound at a varying frequency depending on how often the underlying investments pay dividends.
Last but not least, we have index funds that hold Treasury bills in their portfolios. Also known as T-notes, treasury bills pay interest bi-annually at a fixed interest rate until their maturity.
Since index funds, like other mutual funds, pass on this interest to their shareholders, chances are you’ll receive your interest bi-annually if your fund hotels these investments in its portfolio. As far as compounding frequency goes, the implication here is it’s going to happen on a bi-annual basis.
As you can see, different investments pay interest at varying intervals in a year.
Since some index funds may contain a combination of several investments, it’s also worth noting that the frequency with which an index fund pays out interest may be based purely on the fund’s policy.
Usually, details of this sort will be indicated in an index fund’s prospectus, so be sure to check that document for a definitive answer on the matter.
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To round up our discussion, here’s a summary of everything we’ve established regarding how often interest compounds in an index fund. Typically, index funds pay out interest earned from the investments in their holdings at a varying frequency in a year.
Some may pay once, and others more frequently than that, primarily depending on the type of interest-generating holdings in the fund’s portfolio.
Generally, compounding happens when you reinvest. Thus, interest in an index fund compounds as often as the frequency of the fund’s distributions. I hope that clears things up.
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