Why is everyone talking about index funds? Probably because they're awesome.

Investing in an index fund is like taking the train when you travel. Other methods might get you to your destination faster but might cost more or require more effort. With a train, you only need to know when you want to get on and off. The rest is taken care of by the conductor.

Index funds offer a similar experience for investors. They’re low-cost and hands-off, and once you invest, you can let the fund manager (or index) do the rest.

What are index funds? 

An index fund is a mutual fund or exchange-traded fund (ETF) that aims to mirror the performance of a market index, such as the S&P 500 or the Bloomberg U.S. Aggregate Bond Index.

“Investors who simply want their investments to track or follow the market can invest in index funds without the need to research and pick individual stocks,” says Andrew Crowell, financial advisor and vice chairman of Wealth Management at D.A. Davidson.

Instead, you simply choose an index fund, like picking your train, and hop aboard. The fund manager will do all the hard work of ensuring your fund tracks the index.

What is a market index?

A market index represents a segment of the broader market that the financial industry uses to track the market’s performance. The S&P 500, for example, is used as a barometer for the U.S. stock market by following 500 of the biggest names on the stock market, which collectively represent about 80% of the U.S. stock market.

There are market indexes for almost every part of the market, from stocks to bonds to commodities and currencies. There are even cryptocurrency indexes. 

Within these broader segments, you can find more specialized indexes. For example, the MSCI USA Energy Index tracks companies in the energy sector. The Nasdaq Biotechnology Index narrows the Nasdaq index down to just the companies within the biotechnology or pharmacy industries.

This can make index investing fun for investors because there will likely be an index and index fund to track whatever part of the market you’re interested in.

How do index funds work? 

Index funds work by holding all or many of the securities within the benchmark index. With smaller indexes like the S&P 500, the fund manager will typically hold the same stocks in the same proportions as the underlying index. For instance, if the S&P 500 is 7% Apple stock, an S&P 500 index fund will hold roughly 7% Apple stock.

Fund managers may use a representative mix of the index for larger indexes, which can have thousands of different securities. Fund managers may be able to mirror the Wilshire 5000 index with just 500 stocks instead of all 3,000-plus in the index, says JB Beckett, founder of Beckett Financial Group.

Since an index fund’s goal is only to match the performance of the index it tracks, there’s very little day-to-day fund management. Instead, a fund manager will generally only buy and sell positions to maintain the proper asset allocation required to replicate the index. Ultimately, this keeps ownership costs low, especially for passively managed index funds (which we’ll chat more about soon).

Why invest in index funds?

Whether you build an investment portfolio yourself or work with an advisor or robo-advisor to build one for you, the goal is the same: a well-diversified portfolio with an asset allocation that matches your risk tolerance and time horizon. Index funds can streamline achieving both goals at lower costs than you’d have if you hand-picked individual stocks and bonds.

Instant diversification

When you buy a single share of stock, that’s all you own. But when you buy a share of an index fund, you own a pooled investment with hundreds of stocks or bonds that make up the particular index. You essentially get more for less.

Lower volatility

Since index funds hold hundreds of positions, a loss in one position can often be balanced out by gains or stead values in others. Therefore, you’re less likely to see large swings in value for your index fund shares.

Lower costs

Individual bonds must be bought in increments of $1,000, and stock shares can run as high as hundreds of dollars each if not more. However, you can buy shares of many index funds for well under $100 per share. If you invest with a robo-advisor, they’ll even divvy up your cash and buy fractional shares of index funds to build a well-diversified portfolio and keep costs low.

How much does it cost to own an index fund?

Index funds tend to be low cost since they don’t require as much effort on the part of the fund manager in choosing what securities to buy and sell. But index funds aren’t free; even if they have a 0% expense ratio, you’ll have to pay something to own it—from the cost to purchase to potential taxes.

NAV price

The NAV, or net asset value, price of an index fund is what the index fund is worth based on the value of the securities it holds. NAV is calculated by subtracting a fund’s liabilities from its assets and dividing that value by the number of outstanding shares.

With index mutual funds, the NAV is the price per share for the fund. Index ETFs should also have per-share prices close to their NAV, but since an ETF trades between investors like a stock, the actual price can be higher or lower than the NAV. When this occurs, the ETF is said to be trading at a premium (higher price) or discount (lower price) to NAV.

Expense ratio

The expense ratio is the first thing most investors think of when it comes to index fund costs. It represents the percentage of a fund’s assets that go toward running the fund rather than being invested to generate returns.

The expense ratio gets subtracted from each dollar you invest in a fund. For instance, if a fund has an expense ratio of 0.10%, you’ll pay $1 in fees for every $1,000 invested in the fund.

Tax-cost ratio

Taxes are another cost of investing. Unless you hold your index fund in a tax-sheltered account, like a 401(k) or individual retirement account (IRA), you generally must pay taxes on any capital gains or distributions you get from the fund. As with the expense ratio, every dollar you pay in taxes erodes your long-term returns. Using a site like Morningstar, you can calculate an index fund’s tax cost under the Price tab on its ETF and mutual fund screener.

ETFs and active vs. passive management

The active versus passive management debate is heated and usually comes out in favor of passive management. John Oliver, a popular edutainer and host of “Last Week Tonight,” dedicated an entire show segment to investing costs and the case for low-cost, passively managed index funds.

All in all, only 25% of actively managed index funds beat their passive competitors between 2012 and 2022, Morningstar found. “This means that an investor could potentially have enjoyed better returns at a lower cost by simply owning the underlying index,” Crowell says. However, Crowell notes that some fund managers have track records of outperforming their benchmarks over time. Yet finding and tracking these experienced managers requires research and review, which you may not have the time or inclination to do.

Passively-managed index funds

Most people think of passively managed index funds when they think of index funds. These funds simply mirror an underlying index. If the index adds a stock, the fund adds it. If the index removes it, the fund removes it.

“The primary benefit of passively managed index funds is their low cost,” Crowell says. According to the Investment Company Institute, the average expense ratio for equity index mutual funds was 0.06% in 2021. Still, you can find some with 0% expense ratios, such as the Fidelity Zero Funds.

“The low expense ratio helps to ensure that investors obtain returns very close to that of the underlying index which the fund tracks,” Crowell says.

The drawback to passively managed funds is that you are at the whim of the market. If the index has a bad year, you have just as bad of a year. The fund manager isn’t going to step in and try to shelter you from the worst of the hurt.

“In addition, some index investments exhibit tracking error, which means their returns can deviate over time from their target index, so investors need to do thoughtful research before investing,” Crowell says.

Actively-managed index funds

“Actively managed index funds contrast with passive indexing by applying ‘adult supervision’ to the investment approach,” Crowell says. “For example, an actively managed index fund may overweight or underweight certain stocks or sectors in the index based upon their outlook or valuation.”

The manager may do this to outperform the index in all markets, reduce risk, and minimize the downside. Some argue that active management truly shines during turbulent markets when managers can actively reduce portfolio risk, but the results of 2022 show otherwise. Only 43% made it through the year and outperformed passive managers in the same Morningstar category.

Active managers may have more success in specific market areas. For example, Beckett says active managers for fixed-income funds tend to have better luck beating the bond market returns than equity managers in the stock market.

You’ll typically pay more for this added level of manager supervision. According to the Investment Company Institute, the average expense ratio for actively managed equity mutual funds was 0.68% in 2021. So, if you choose to use an actively managed index fund, make sure the added benefit is worth the higher cost.

How to invest in index funds

The beauty of investing in index funds is that it’s easy. You don’t need a Ph.D. or a ton of money to do it. Simply open a brokerage account and follow these steps.

1. Set an investing goal

Every investment strategy should begin with a goal. You want to start with a clear understanding of why you’re investing and how long you have to achieve this goal. 

“For example, a young investor saving for retirement has a long time horizon and can afford to take risks which a retiree should not,” Crowell says.

Your goal will help you determine which index is the most likely to help you reach that goal.

2. Do some research

Index fund investing is easy, but it isn’t homework-free. When selecting an index fund, you need to research which index and fund best fits your goals.

“Resources such as Morningstar or the index fund provider’s website will provide detailed information on historical returns, asset allocation, expenses, [and] investment approach, which can assist in finding the most appropriate investment for the investor’s goals,” Crowell says.

3. Select your funds

Once you know the index or indexes you want to track, you need to choose your funds. If you opt for passive management, you generally want to choose the least expensive fund that performs similarly to its underlying index. 

“Fee drag is real,” Beckett says. Even a small expense ratio can eat into your long-term returns, which is another reason it’s so hard for active index funds to outperform their passive counterparts; the active index fund manager has to beat the index by more than the cost of the fund for investors to make a profit.

You can tell how well an index fund tracks its index by looking at its returns—how similar they are to the underlying index—and tracking error, which is the difference between a fund’s annual returns and that of its index. The lower the tracking error, the better.

You’ll also want to keep diversification in mind. Beckett likes to see investors with a mix of passive index funds. “The S&P 500 is not always going to be the best performer,” he says. That said, if you’re just starting out and only have a few hundred dollars to invest, one fund may be enough.

4. Decide how to buy your index funds

You can purchase index funds through a brokerage firm or the fund provider’s website. Most people opt for the former since this will give you more investment options. Fund providers only sell their funds, whereas brokerage firms give you access to index funds from a wide variety of fund companies. 

When choosing a brokerage firm, pay attention to its fees and account minimums. Some companies charge trading commissions or account maintenance fees that can chip away at your returns.

5. Buy your index funds

There are two ways to buy index funds inside a brokerage account: by the share or the dollar. Traditionally, only mutual funds let you place dollar-based trades. However, some brokerages now let you buy ETF shares in dollar increments. This can be helpful for investors with a specific amount of money since share prices can fluctuate and are seldom round numbers.

6. Track your investments

While index funds are great hands-off investments, you shouldn’t completely set it and forget it. Becket says you’ll want to monitor and reassess your portfolio over time. As your account grows, you may want to add more funds to your mix to increase your diversification.

The takeaway 

Index funds are great foundations for many investment portfolios. They’re a low-cost way to get diversified exposure to almost any financial market segment. 

While you can pay a little extra for active management, this isn’t necessary and often isn’t even profitable. Instead, Beckett says that most investors do best by building a portfolio and regularly checking in on its progress to ensure your goals stay on track.

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