How to Invest in Index Funds

Article Summary:

Investing in index funds is simpler, cheaper, and more diversified than building a portfolio by yourself. There are index funds for every risk tolerance and strategy. Discover the best way to avoid unnecessary fees and create an index fund investment strategy with a minimal initial investment.

Over the past decade, index investing blossomed into one of the most popular strategies on Wall Street. Currently, 51% percent of the assets invested in U.S. equity funds are invested in index funds, up from 28% in 2011, according to Morningstar Direct.

An index is a benchmark against which a market is measured. By taking a sampling of a specific asset class, the index reports broad investor sentiment.

7-Step process to index fund purchase

  1. Write down your investment goals (retirement, new house)
  2. Determine your risk tolerance: Will you be able to sleep if the market falls more than 10%? No = low-risk tolerance.
  3. Determine what you want to invest in? Large U.S. companies, small U.S. companies, tech stocks, International stocks, and corporate bonds are very popular.
  4. Find index funds that best fit your strategy. Don’t forget to compare fees.
  5. Open an investment account, either directly with a mutual fund or with a discount broker to buy ETFs.
  6. Purchase shares in the index funds you selected.
  7. Set up a plan to invest regularly in your index funds.

How to buy index funds

When buying index funds, compare expense ratios and make sure they hold the securities you want to own.

ETFs trade on the stock market. The cheapest way to buy them is through a discount broker that charges zero commissions. If you want a mutual fund, you buy the shares directly from the fund or through a financial advisor. Make sure the mutual fund is a No-Load fund. A load is another name for a commission.

These brokerages provide free online trades and give access to mutual funds and ETFs.

Hundreds of indices

The S&P 500 Index is one of the most famous indices in the world. It tracks the stocks of 500 of the largest companies in the U.S. Currently, 20% of all the assets in index funds track the S&P 500, according to Morningstar. The other 80% is invested in hundreds of indices that track every market niche and strategy, such as:

  • Company Size: Some indices focus on just one company size (big, medium-sized, small, or micro), others cover the entire market.
  • Geography: You can find indices for almost every country, continent, and area of the world, such as developed nations or emerging markets.
  • Industry: Almost every business sector, such as technology, energy, and utilities, has an index.
  • Strategies: There are indices that track specific investing strategies such as growth, value, and hedge fund.

Indices are not portfolios

Indices are not portfolios. You can’t invest in them directly. They are mathematical constructs to measure and report the health of that market.

Funds are portfolios you can buy into

A fund is a portfolio in which you, the average investor, can buy shares. Buying into a fund gives you the services of a portfolio manager (PM) at a reasonable price with minimum investment. Instead of researching financial assets in your free time and buying them on your own, the PM takes care of that.

Funds are cheaper than DIY

Building a diversified portfolio of individual stocks and bonds requires a lot of money and can incur significant commissions and fees. With a fund you start with a small initial investment, pay few or no commissions, and small management fees. The fund manager pools the cash from many investors, allowing him to buy shares of many stocks to create a diversified portfolio.

In an index fund, the manager doesn’t do much research because he just buys the components of the index to create a portfolio that tracks the benchmark’s performance. Less research means lower costs.

Mutual funds and ETFs

Index funds come in two different shapes: mutual funds and exchange-traded funds, known as ETFs. They both allow all investors to buy shares in their portfolios.

The big difference is ETFs trade on the stock market, mutual funds don’t. Mutual funds can be bought just once a day at one price. Like stocks, the prices of ETFs move during the trading day. This gives you flexibility on when and how much you pay. ETFs are typically cheaper and more tax-efficient than mutual funds.

Some funds track indices exactly, others Don’t

If you were to buy an S&P 500 index fund, you would purchase a fund or ETF that replicates the benchmark’s returns by holding all the stocks in the index. Vanguard index funds and Fidelity index funds are some of the most popular funds available.

The Vanguard S&P 500 ETF (Ticker: VOO) tracks the index exactly. The fund’s expense ratio, or management fee, is 0.03%. This means every year you pay the fund $3 for every $10,000 you have invested.

Other funds, such as the Fidelity Zero Large-Cap Index Fund (FNILX), is a mutual fund that tracks an index that holds many of the same companies as the S&P 500, but not exactly. By not paying a fee to put “S&P 500” in its name, it passes along the savings to investors by not charging an expense ratio, or what it calls “zero expense ratio,” and requiring no minimum investment.

Sometimes the fund will approximate the benchmark if many of the index components are illiquid or small. The iShares Core U.S. Aggregate Bond ETF (Ticker: AGG) tracks a benchmark for the U.S. investment-grade bond market. The index holds about 12,300 individual securities. Yet, the fund only holds 9,900. The expense ratio is 0.04%.

Funds have a lower-risk profile than a portfolio of individual securities because funds are more diversified. However, there’s no downside protection. When the index falls, your investment falls the same amount. Nor are all index funds low risk. Risk depends on the assets in the fund. A biotechnology index fund is riskier than a utility index fund.

Another downside of index funds is they rarely beat the market. Most funds don’t track the benchmark perfectly. That’s because there are expenses involved with running a fund, such as management fees and transaction costs.

Index funds vs. active mutual funds

Index funds follow a passive management strategy. Because the manager just buys what’s in the index, once the portfolio is built, the stock selection seldom changes. This means a lot fewer transaction costs.

Passive is the opposite of actively managed funds. An active fund manager is allowed to buy and trade whichever securities he wants, whenever he wants. A major benefit of index funds is they have lower costs than active funds.

Rebalances strategy

Younger people can afford to take more risk as they have more time to build back assets after a market decline.

Rebalancing is a strategy that makes sure you’re not taking on too much risk and keeps your asset allocation in balance with your risk tolerance. If you invest 30% of your portfolio in a growth index and it grows to 50% of your portfolio, you rebalance by selling enough shares to bring back down to 30%. Then put that money into funds that have seen their allocation fall and bring it back up. This helps you sell at high prices and buy at low prices.

Build your portfolio

In addition to the funds already mentioned, here’s a list of ETFs that track the top indexes.

  • Total U.S. Stock Market: Vanguard Total Stock Market ETF (VTI)
  • Small-Cap U.S. Stocks: iShares Russell 2000 ETF (IWM)
  • U.S. Growth Stocks: Vanguard Growth ETF (VUG)
  • U.S. Value Stocks: Vanguard Value ETF (VTV)
  • Developed Markets: iShares Core MSCI EAFE ETF (IEFA)
  • Emerging Markets: iShares Core MSCI Emerging Markets ETF (IEMG)

Investing in a variety of indexes allows you to diversify your portfolio further.

Pros and cons of index funds

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and the drawbacks to consider.

Pros
  • Easy to build a diversified portfolio
  • Cheaper than actively managed funds.
  • Minimum initial investment
  • Low cost
  • Mirror the market’s return.
  • More tax-efficient than active funds.
  • Less time spent on research
  • Less risk than a small portfolio of stocks
Cons
  • No downside protection. When the index falls, funds fall.
  • Not all index funds are low risk. It depends on underlying holdings
  • Don’t beat the market.

Key takeaways

  • Buying index funds is a good choice for most investors.
  • With a small initial investment, an investor can own a diversified portfolio at a low cost.
  • Not only is this cheaper than building a portfolio of individual securities by yourself, but index funds are also less expensive to hold than active mutual funds.
  • Index funds track the performance of the index they follow, so even if some stocks in the index don’t do well, if the overall index rises, you make money.
Article Sources
  1. Introduction to investment – SEC
  2. S&P Dow Jones Indices – S&P Global
  3. Brokerage reviews and comparisons – SuperMoney