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Index Funds: How to Invest and Choose the Best Funds

What is an Index Fund

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If you’re investing in the market today, there’s an excellent chance you’re doing it – or will be doing it – using index funds.  There are plenty of reasons why index funds are a superior core investment strategy in just about any portfolio.

But if you’ve never done it before, it’s important to learn how to invest in index funds before taking the plunge.

On balance, index funds are one of the very best investments you can make. But like all investments, they do have their own nuances, and are never entirely risk-free.

In this guide, we’ll show you what to be aware of with index investing, including the potential downsides.

A Brief History of Index Funds

The first index fund was launched on December 31, 1975, by Vanguard founder Jack Bogle. His mission was to create a passive investment fund, that tracks the underlying market, rather than attempting to outperform it.

And since the fund would be tied to an index – and involve very little trading – the fees associated with the fund would be very low low.

For the most part, Bogle was looking for an alternative to mutual funds. Mutual funds are actively managed portfolios that attempt to outperform the market.

The fund manager emphasizes what he or she believes to be companies likely to outperform the general market.

The only problem with that strategy is that most fund managers don’t outperform the market. If fact, the vast majority under-perform it.

In just the last 15 years alone, 92% of large cap mutual fund managers trailed the performance of the S&P 500.

Index Funds vs. Actively Managed Funds

If most fund managers underperform the general market over the long term, Bogle reasoned it would be to the advantage of investors to participate in a fund designed only to match the market.

Index funds have another big advantage over actively managed mutual funds, and that’s in the form of lower fees.  Many mutual funds charge what are known as “load fees”, ranging from 1% to 3% of the investment made.

For example, if a mutual fund charges 1% on purchase, and 1% on sale, a $10,000 investment will cost $100 upfront, then another $100 upon sale.

And when John Bogle launched the first index funds, mutual fund load fees were often much higher than 3%. Since they are not actively managed funds, index funds don’t charge load fees.

The absence of these fees by itself increases the performance of index funds compared to mutual funds.  That, in addition to the fact that index funds typically outperform mutual funds simply by matching the market.

It’s small wonder then that investments in index funds have grown from zero in 1976 to $4.271 trillion dollars in the third quarter of 2019.

And for the first time in history, investments in index funds now exceeds money held in actively managed funds.

What is an Index Fund?

Strictly speaking, an index fund can be either an exchange traded fund (ETF) or a mutual fund.  However, they’re most commonly ETFs, while most mutual funds are actively managed.

An index fund is essentially a portfolio of stocks tied to a specific index.

For example, probably the most common index the funds are tied to is the popularly tracked and quoted S&P 500 Index.  The index represents stock in the approximately 500 largest publicly traded companies in the US.

Using the S&P 500 index as an example – there are many other indexes that we’ll cover in this guide – the index fund matches the composition of the index, including a proportional interest in each of the 500 or so stocks the index includes.

In that way, the index fund tracks the S&P 500 index with almost mathematical precision.

Though the investor will never outperform the market – because the index is the market – he or she will never underperform it either.

Because an index fund tracks and underlying index, it’s referred to as passive investing.  It’s passive because the fund doesn’t actively trade stocks, looking to increase holdings in top performers, while selling off laggards.

Instead, the fund stays invested in the companies that make up the index.  This leads to very little trading activity within an index fund. The fund will buy or sell shares only when there’s a change in the index.

For example, that might happen when new stocks are added to the index, or existing ones are dropped.

This is unlike active investment management, where the fund manager regularly buys and sells stock in various companies in an attempt to outperform the market.

Index Funds have Lower Expense Ratios than Actively Managed Funds

The passive nature of index funds leads to lower investment costs. As we’ve already discussed, index funds don’t have load fees.

But the lack of active management and trading also means lower expense ratios. These are expenses charged by a fund to manage it.

In actively managed funds, the expense ratio can be as high as 1% per year. In passively managed index funds, It’s typically around 0.20% per year.

Lower expense ratios translate into better investment performance, especially over the long term, since returns are less affected by internal fees.

What to Look for When Choosing Index Funds

Since virtually all index funds have the same goal – to match the underlying index – does that mean which fund you choose is irrelevant?

Not at all.

There are two important factors to take into consideration when choosing among index funds:

  1. How well the fund matches the underlying index, and
  2. Expense ratios.

 Let’s look at each in greater detail.

How well the fund matches the underlying index

The most fundamental reason to invest in index funds is to match the performance of the underlying index.

In a perfect world, each index fund would match the performance of the underlying index exactly. In the real world however, there are variations.

Most funds tend to perform slightly worse than the index, usually due to expense ratios.

You can determine the performance of the fund versus the index by looking at the information available on any fund you want to invest in.

Let’s use the Vanguard S&P 500 ETF (Symbol: VOO) as an example.

Index Funds Performance

Index Funds Performance

Let’s focus on the five-year performance, since long-term is always more important than the most recent year.

You’ll notice that the S&P 500 ETF Market Price has a five-year return of 10.96%. That almost perfectly matches the S&P 500 Index Benchmark of 10.98%.

But when comparing index funds to each other, how well each fund matches the underlying index is a critical criteria.  Not all funds come this close to matching the index. And with the vast majority, the variation is to the negative side.

Expense ratios

Earlier we discussed that all funds have expense ratios. But they can vary considerably from one fund to another.

Even though index funds have an average expense ratio of 0.20%, some are higher, and some are lower. You can also find this information on the webpage of any funds you’re interested in.

Continuing with the Vanguard S&P 500 ETF, the screenshot below shows the expense ratio for this fund to be 0.03%.

That’s one of the lowest in the industry, and it’ll certainly have a better long-term performance than a similar fund with an expense ratio closer to the average of 0.20%.

Index Funds Expense Ratios

Index Funds Expense Ratios

Important note on expense ratios: Unlike load fees and commissions, expense ratios aren’t direct charges to the investor.  Instead, they represent internal charges. You’re never presented with a bill for the amount of the expense ratio.

Instead, the amount of the charge is deducted from the value of the fund.  Put another way, unless you regularly monitor the expense ratio of a fund, you won’t even be aware it exists.

But it always matters, because when two index funds have essentially identical overall performances, the fund with a lower expense ratio will provide higher returns to the investor.

Different Types of Index Funds Available

So far, we’ve been discussing index funds that are tied to general market indexes, like the S&P 500.

But there may be as many as 130,000 different investment indexes, which is curious considering that’s far more indexes than there are publicly traded stocks in the US.

But if you choose to invest in index funds, you can use the many sector funds to spread your portfolio across an amazing diversity of investment types.

Examples of the many different index fund types available include:

  • Foreign developed markets – stocks from companies based in Europe, Japan, Australia, and Canada.
  • Foreign emerging markets – stocks from less developed markets, like Mexico, South America, India, and other developing countries.
  • Mid-cap stocks – stocks in medium-sized US-based companies.
  • Small-cap stocks – stocks in small US-based companies.
  • Micro-cap stocks – stocks in very small US-based companies.
  • Value stocks – companies trading at less than their revenues and earnings would indicate.
  • Industry sectors – indexes based on specific industries, like healthcare, technology, energy, real estate, precious metals, manufacturing, or financial companies.
  • Bond indexes – for investing in broad bond markets, like high grade US corporates, international bonds, high-yield US bonds, short-term US treasuries, medium-term US treasuries, long-term US treasuries, and municipal bonds.

That’s just a short list. But the point is, it’s possible to build a highly specialized portfolio using a mix of index funds based on various highly specialized indexes.

If you’re going to go this route, be sure you have at least a general understanding of how the specific underlying market works.

For example, if you want to invest in an index fund based on energy, you should have some knowledge of that sector.

Because there are so many different index fund sectors, picking which ones to include in your portfolio can closely resemble selecting individual stocks.

Index Funds Advantages

There are many reasons why index funds have overtaken actively managed funds as the most common type of fund investing.

The main ones include:

Ease of Investing

Investing in index funds is virtually identical to investing in stocks.  You can choose the fund or funds you want to invest in, then make the investments online.

This can be done either through the fund family that holds the fund, or through an investment brokerage that makes the fund available.  Similarly, you can sell your position in the fund at any time, and just as easily.

Though index funds are not typically designed for active traders, the ease with which you can buy and sell your positions does offer that opportunity.

Very Low Cost

As discussed earlier, index funds don’t have the load fees more typically charged by actively managed funds.  If you purchase them directly through the sponsoring fund family, there are generally no transaction fees.

What’s more, since most investment brokers have done away with trading commissions, you can also buy index funds on brokerage platforms without paying fees.

That’s true whether you buy or sell your position in the fund.

Generally speaking, the only fees you’ll need to be concerned with when it comes to index funds are expense ratios. And those are generally extremely low.

The absence of fees will improve the long-term performance of your investment, compared to both actively managed funds and individual stocks.

Generate Less in Taxable Capital Gains

This gets back to active management versus passive management.  Since index funds are passively managed, they neither buy nor sell stocks on a regular basis.

This limits the amount of capital gains they generate, unlike actively traded funds which may regularly produce gains.

Since capital gains are taxable, either as ordinary income (short-term capital gains), or at lower rates on long-term capital gains, minimizing those gains also reduces your tax liability.

And since the funds hold their stock positions for many years, allowing them to grow in value, it represents a form of backdoor tax deferral.

Your fund can continue growing in value without creating taxable capital gains.  Most of the gains will only be realized once you sell your index fund at a higher value than you purchased it for.

Broad Diversification

When you buy individual stocks, it can be very difficult to diversify across a large number of companies, let alone different industry sectors or asset classes.

And even though actively managed funds typically hold anywhere from a few dozen to a few hundred stocks, that’s usually less than the number held in index funds.

Since index funds are based on an underlying index, they can hold hundreds or even thousands of companies.

For example, any index fund based on the S&P 500 index will have positions in approximately 500 of the largest companies in the US.

But some funds may be based on indexes with an even larger number of companies.

No Special Investment Knowledge

When you invest in index funds, you don’t need to have any investment knowledge.

Since you’re not investing in individual stocks, you don’t need to perform the tedious research required to do so. Instead, you’re investing in an entire market or market sector, which is fully managed for you.

With that said, it’s always an excellent idea to learn as much about the markets as possible, as well as investing in general.

That will at least help you to decide what specific funds you’ll invest in, as well as diversification into other assets, like fixed income securities or real estate investment trusts (REITs).

Low Investment Minimums

Unlike actively managed funds, which often require minimum initial investments of anywhere from $1,000 to $3,000 or more, index funds – which are typically ETFs – either have very low minimum initial investments, or no minimum requirements at all.

This makes index funds perfect for small investors. It enables you to diversify a relatively small portfolio across several different funds.

Invest in Any Sector

As we discussed earlier, index funds are available for just about every market sector. You can choose to invest in the general market, through an index fund based on the S&P 500, or specific sector funds.

For example, if you believe technology or healthcare will outperform the general market, you can invest in index funds based on healthcare or technology indexes.

Similarly, if you believe inflation is about to heat up, you can choose to invest in index funds based on energy or precious metals indexes.

You can create a portfolio made up of as many market sectors as you choose.

Used by Investment Managers and Robo-advisors

If you’re at all unsure about investing in index funds, you can be reassured by the fact that they are wildly popular in managed accounts.

Traditional human investment managers often use them in creating portfolios for their investor clients.

But among robo-advisors, they’re virtually an investment standard. Most robo-advisors will invest your entire portfolio in index funds. 

Those funds can be based on foreign and domestic stocks, foreign and domestic bonds, and even alternatives, such as real estate and natural resources.

The fact that the professionals are using index funds so frequently tells you you’re on the right path.

Index Fund Disadvantages

As perfect as index funds seem to be, they aren’t without some downsides. In the interest of full disclosure, we’re providing a few of those as well.

Exact Opposite of Self-directed Investing

While index funds may be the perfect way to invest for anyone not familiar with the process of investing, they’re of only limited use to self-directed investors.

If you have a preference for selecting your own stocks, perhaps because you have a history of outperforming the markets with your own picks, index funds probably won’t figure significantly in your portfolio allocation.

After all, index funds are the exact opposite of self-directed investing

They’re designed to be pure passive investments for people who have little interest in picking their own stocks and managing their own portfolios.

Put another way, index funds aren’t for every investor.

Will Never Outperform the Market

This is a point I hope we’ve made clear throughout this guide. The fundamental purpose of index funds is to match the performance of the underlying index.

While that means you’ll never underperform the market, it also means you’ll never outperform it either.

If you’re hoping to outperform the market – and who isn’t – you’ll need to consider either actively managed funds, or investing in individual stocks.

However, neither strategy has proven to outperform the market over the long term, and each comes with greater risk than index fund investing.

Not Immune to Market Downturns – or Crashes

Though index funds have been around since 1976, the public stampede into them has primarily taken place in the past 20 years.

The growth has been even more significant in the last 10 years, which has been highlighted by a near perpetually rising market.

If you began investing in index funds any time from 2009 on, you may be of the belief that you can’t lose money investing in them.  Unfortunately, that assumption is categorically untrue.

Remember – index funds neither outperform nor underperform the underlying market.  Sure, when the markets are rising, they’re taking your index funds up with them.

But the same is true on the downside. If the markets fall, your index funds will go down with them.

As an example, if an S&P 500 index fund – or even a specific sector fund – were to fall something like 50% or more, your index fund would fall by a similar amount.

This is a reality that many recent index fund investors have not experienced.

And since many of those investors have little understanding of the financial markets, it will come as an unpleasant surprise when the markets reverse, and take index funds down with them.

Investments in Markets, Not Stocks

One of the advantages to index funds is also possibly a disadvantage. Index fund investors don’t need to know anything about stocks.

But that arrangement can blind investors to the very real risks they’re taking on by investing in the stock market, even with index funds.

For example, if you invest in an index fund based on one or more sector funds that have been performing well in recent years, you may be caught by surprise if there’s a sudden reversal.

Often there are indicators that a company or a sector are overpriced and ripe for fall. But unless you’ve at least studied the market and the sectors you may be completely unaware of the signs.

Even worse, index funds may have created an environment in which investors show little concern for stocks themselves.

If you’re investing only in markets, which is exactly what you’re doing with index funds, it can lull you into believing that stocks don’t matter.

But they matter plenty, because they’re the very foundation of the index fund.

It’s also worth noting that in his final interview, index fund founder John Bogle himself warned that index funds had gotten so large that they virtually control the markets.

Which is an excellent segue into what is perhaps the biggest disadvantage of index funds…

The ultimate reality of the financial markets is that they both rise and fall.

If all they ever did was rise, the S&P 500 index would likely have crossed 100,000 by now. Periodic crashes and bear markets keep that from happening.

Even if you know absolutely nothing about investing, you should be aware of at least that much – even when it comes to index funds.

Where to get started investing

If you want to invest in index funds, there are three primary ways to do it. But within each category there are many different providers.

Nearly every investment organization in existence now offers index funds to their customers.  Three primary sources are investment brokers, index fund families, and robo-advisors.

Investment Brokers

You’d be hard-pressed to come up with an investment broker that doesn’t offer a large selection of index funds.

But some of the most popular brokers – all of whom make index funds available with no transaction fees – include the following:

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Large Index Fund Families

Though diversified investment brokers are often the easiest and most convenient way to invest in index funds – not the least of which because they offer a full range of other investment types – you can also invest through fund families.

Fund families will typically include a large number of funds comprised of actively managed mutual funds, as well as index-based mutual funds and ETFs.

You can invest directly with these fund families, purchase shares in one or more index funds, and usually do so free of charge.

Examples of some of the most popular fund families available include:

Robo-advisors

Robo-advisors are automated, online investment platforms that manage your money for you for a very low annual fee. They’ll determine your risk tolerance, investment goals, investment time horizon, and design a portfolio for you.

Once your portfolio is up and running, they’ll also manage it for you on an ongoing basis.

That includes periodic rebalancing, to make sure your investments remain consistent with your portfolio target allocations, as well as automatic reinvestment of dividends.

The process is totally automated, and once you establish your account all you need to do is fund it on a regular basis.

The typical robo-advisor will provide this service for an annual fee ranging between 0.25% and 0.50% of your account balance.

For example, if a platform charges an annual management fee of 0.25%, you can have a $100,000 portfolio fully managed for just $250 per year.

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So, what do robo-advisors have to do with index funds? Everything!

Most robo-advisors invest your entire portfolio in index-based ETFs.

You’ll typically have US and foreign stocks, US and foreign bonds, and possibly real estate, natural resources, and select sector funds.

Robo-advisors not only invest your money in index funds, but they choose the mix of funds for you.  Popular robo-advisors include Betterment, Blooom, and M1 Finance.

M1 Finance is a particularly interesting robo-advisor. They use an investment method they refer to as “pies”.

Each pie is actually a mini portfolio, comprised of as many as 100 securities. You can include either ETFs or individual stocks in your pies.

The platform provides both predesigned pie templates, as well as the ability to create your own. Meanwhile, M1 Finance charges no annual management fee.

Should You Invest in Index Funds?

Index funds are an appropriate investment class for any and all investors. But they’re especially valuable to those who want to invest but don’t have either the knowledge or the experience.

All you need do is invest your money, and you’ll be guaranteed to at least match the performance of the underlying market index.

Though they can be used for taxable investment accounts, they’re especially valuable with retirement accounts.

Most employer sponsored retirement plans offer index funds. And if you hold your retirement funds in a traditional or Roth IRA, you can select the investment platform where your account will be held.

Whether that’s an investment broker, a fund family, or a robo-advisor, you can invest your money primarily or entirely in index funds.

Since the long-term history of the stock market is to rise – despite periodic declines – index funds are the perfect passive way to invest for retirement.

You can use index funds whether you’re saving and investing for retirement, or already retired.  In fact, they may be especially important for retirees.

Because they’re passive, you’ll be able to hold at least some of your portfolio in index funds, along with fixed income investments, and enjoy a worry-free retirement.

But once again be reminded that index funds, just like the financial markets, both rise and fall.  If the markets go into a tailspin, your index funds will fall as well.

But you won’t be in any danger of doing any worse than the market in general. And the likelihood you’ll make up the losses over the long-term is very good.

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