Index funds have become a major force in the investing world. As a matter of fact, as far back as in 2016, more than $1 out of every $5 invested in the equity markets in the United States was believed to be invested through the conduit of an index fund.
Index funds work by matching or tracking a market index to generate a return on investment. They do not change in response to the market and are considered stable, passive investments. In simple terms, an index fund is a mutual fund that, instead of having a portfolio manager making selections, outsources the capital allocation job to the individual or committee determining the index methodology. That is, if you buy a Dow Jones Industrial Average index fund or ETF (exchange traded fund), you’re really just handing over the job of managing your money to someone else.
How to Invest in Low Cost Index Funds
- Decide where to buy: You can purchase an index fund directly from a mutual fund company or a brokerage. Same goes for exchange-traded funds (ETFs), which are like mini mutual funds that trade like stocks throughout the day.
Here are some factors to consider when choosing where to buy index funds;
- Fund selection: Do you want to purchase index funds from various fund families? The big mutual fund companies carry some of their competitors’ funds, but the selection may be more limited than what’s available in a discount broker’s lineup.
- Convenience:Find a single provider who can accommodate all your needs. For instance, if you’re just going to invest in mutual funds (or even a mix of funds and stocks), a mutual fund company may be able to serve as your investment hub. But if you require sophisticated stock research and screening tools, a discount broker that also sells the index funds you want may be better.
- Commission-free options: Do they offer no-transaction-fee mutual funds or commission-free ETFs? This is an important criterion we use to rate discount brokers.
- Trading costs: If the commission or transaction fee isn’t waived, consider how much a broker or fund company charges to buy or sell the index fund. Mutual fund commissions are higher than stock trading ones, about $20 or more, compared with less than $10 a trade for stocks and ETFs.
- Pick an index: Index mutual funds track various indexes. The Standard & Poor’s 500 index is one of the best-known indexes because the 500 companies it tracks include large, well-known U.S.-based businesses representing a wide range of industries. However the S&P 500 is not the only index that you can invest in. There are indexes — and corresponding index funds — composed of stocks or other assets that are chosen based on:
- Company size and capitalization: Index funds that track small, medium-sized or large companies (also known as small-, mid- or large-cap indexes).
- Geography: These funds focus on stocks that trade on foreign exchanges or a combination of international exchanges.
- Business sector or industry: Funds that focus on consumer goods, technology, health-related businesses, for example.
- Asset type: Funds that track domestic and foreign bonds, commodities, cash.
- Market opportunities: Emerging markets or other nascent but growing sectors for investment.
Even though there are a lot of enticing choices, you may have to invest in only one. Warren Buffett has been known to say that the average investor needs only invest in a broad stock market index to be properly diversified.
- Check investment minimum, other costs: one of the main things that draws people to index funds is the low costs involved. They are cheap to run because they are automated to follow the shifts in value in an index. However, don’t assume that all index mutual funds are cheap.
Even though they’re not actively managed by a team of well-paid analysts, they do not mean that they are totally devoid of any additional cost implication. These costs are subtracted from each fund shareholder’s returns as a percentage of their overall investment.
Two funds may have the same investment goal — like tracking the S&P 500 — yet their management cost may differ greatly. Those fractions of a percentage point may seem like no big deal, but your long-term investment returns can take a massive hit from the smallest fee inflation. Typically, the bigger the fund, the lower the fees.
Here are the main costs that you should have in mind:
- Investment minimum: this is the minimum amount that you are required to invest in a mutual fund and it can run into a few thousand dollars. Once you’ve crossed that threshold, most funds allow investors to add money in smaller increments.
- Account minimum: this should not be confused with the investment minimum. Although a brokerage’s account minimum may be $0 (common for customers who open a traditional or Roth IRA), that doesn’t remove the investment minimum for a particular index fund.
- Expense ratio: This is one of the main costs which are subtracted from each fund shareholder’s returns as a percentage of their overall investment. Find the expense ratio in the mutual fund’s prospectus or when you call up a quote of a mutual fund on a financial site.
- Tax-cost ratio: In addition to paying fees, owning the fund may trigger capital gains taxes if held outside tax-advantaged accounts like a 401(k) or an IRA. Just like the expense ratio, these taxes can reduce the returns that you will get on your investment.
Pros of Investing in Index Funds
There are a lot of advantages that are associated with investing in index funds, especially for poorer investors. Some of them include;
- Index is no magic word. Indices can be good, bad or just plain average as long as the investor realizes there is nothing magical about the word “index” – there are good indices, bad indices, and mediocre indices – and selects an intelligent underlying index run by a stable and responsible asset management company, it should provide a satisfactory way to participate in whatever underlying market it represents with a single purchase. That has a lot of convenience and can mean lower transaction costs, which matters if you’re only investing something like $25,000 or $50,000 and commissions could eat up a meaningful amount of your principal if you attempted to build your own 30, 50, 100+ stock portfolio directly in a brokerage account.
- Many index funds in the equity market tend to be run in a way that minimizes turnover. Low-turnover, has long been a key to successful investing. In fact, a lot of research has shown that investors would be better off in many cases buying the underlying index components directly, as individual stocks, and sitting on them with no subsequent changes at all than they would be by investing in the index fund itself.
- Index funds have an enormous psychological advantage for people who are not inherently good with arithmetic. Do not underestimate how incredible this can be in saving a family from financial hardship and ruin due to its influence on behavior. A lot of men and women, who otherwise might be intelligent, good people, lack a basic grasp on how numbers interact together.
- Index funds, by nature of being diversified already, diffuse the dangers of investors who suffer from a cognitive bias called irrational escalation.
- Index funds force people who cannot value businesses, and thus have no business owning stocks, to avoid the temptation to select individual ownership stakes in different enterprises.
Cons of Investing in Index Funds
Investing in index funds is not without its disadvantages. These become more pronounced the more successful you are.
- You need to understand that index funds are a crude approximation of the thing that makes them work. They are not ideal, they are simply “good enough”. When you look at the underlying academic evidence, it is overwhelming in demonstrating that, historically, success most frequently arises for investors who: Combine diversified equity ownership with Long ownership periods due to low turnover and Keep costs low.
For lower and middle class investors, the index fund was the only way to achieve that if you didn’t want to devote a lot of time to your portfolio.
- Purely Passive: Index funds are passive. They mirror the market as a whole as closely as possible, investing as widely as they can to avoid massive plummets in value. Ordinarily, this means that an index fund is fairly safe, but if the market itself is heavily involved with stocks that are unsafe or just inflated in value, then the inevitable crash destroys the value of your index fund. A managed fund, on the other hand, can identify those unsafe funds and either avoid them or attempt to live the “Buy low, sell high” mantra.
- No Control: Another disadvantage of index funds is that investors are involved with and supporting all the companies on that index. If an investor dislikes a company for moral or personal reasons but that company is on his index, he has no way of removing his money from that company without exiting the index fund entirely. With a managed fund, on the other hand, all it takes is a simple call to the manager stating that he does not want to have money involved with that company.
- Risk and Reward: some would say that investment is comparable to legalized gambling, but instead of taking a blind leap of faith, an investor is putting money toward which companies will do well in the future and away from those which will not. Choosing one’s own investments or leaving them to a trader is risky because it involves the human element, but it’s also where the big rewards come from.