An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index. This fund provides broad market exposure, low operating expenses and low portfolio turnover. They equally adhere to specific rules or standards that stay in place no matter the state of the markets.
When investors buy an index fund, what they usually get is a well-rounded selection of many stocks in one package without having to purchase each individually.
The beauty of index funds is that you’ll get a neat package of bundled stocks. Therefore, as an investor, you don’t have to pay a money manager to choose your investments for you because they have already been selected. You only need to pick the bundle that suits your purposes. This means that index funds typically give way to high returns and lower fees in the process.
Index funds are not a recent investment concept. It has been here long enough but most investors are just getting to know about it. Research has revealed that as of 2016, $1 out of every $5 invested in the equity markets were invested as one form of index or the other.
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Why you should invest in index funds
Liquidity in this case simply means that you can buy or sell at the end of the trading day at the fund’s net asset value. Though they’re not as liquid as stocks, which can be bought or sold at any time during the trading day, mutual funds are still some of the most liquid investment options available. ETFs can be the best of both worlds, in that they offer diversification and can be purchased on margin like stocks and you can short-sell them, too. They also trade at a price that is updated throughout the day, just like stocks. You’ll get real-time pricing every time you buy and sell.
It is a passive investment
Investing in an index fund is a form of passive investing. The primary advantage of such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500. Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts because of its passive nature.
Index funds can have much lower taxes than traditional mutual funds. Many index funds have very low turnover in the stocks held. Index funds pay fewer dividends than actively managed mutual funds and they also have a low turnover rate. Low turnover equals low taxes, so index funds are a great place to park your money if you are interested in lowering your tax burden.
The only time a fund will incur capital gains, which result from buying and selling a stock position, is when it has to sell its entire position in a stock because the index it is tracking changes. Even then, the portfolio manager may be able to offset those gains with losses in the position its selling or elsewhere in the portfolio.
They are cheap
Index funds are very inexpensive. Not only can you often buy an index fund without paying a commission, but they have very low expense ratios and don’t generate much capital gains. That means taxes and fees won’t eat into your portfolio. Index funds can help you keep more of your money for yourself.
The downside of investing in index funds
Index funds don’t represent all sectors and industries, and as such they favor only certain sectors, and you may not be able to see huge gains or growth in your investment. Since index funds follow an index, they’re not going to see the type of gains you could see as a day trader. Other downsides of the index fund include;
They are susceptible to high volatility: Index funds are highly volatile in nature, though a money manager can lessen the impact if he or she is knowledgeable about it.
They can be overvalued: If based on a company’s price-earning ratio, expected earnings or condition, or if the stock price is deemed too high, then it is overvalued. It is quite easy to have a lot of overvalued stocks in your index, and this can take a rip out of your profits.
The index rule makers make all the decisions: This means that you are relinquishing control over your holdings. Your investments in an index fund are made at the whims of the index rule makers. So, even if you dislike a company and don’t want to own its stock, you’ll have to go with them if they are part of the index you chose. Likewise, you might find an index is perfect except it’s missing a company or two that you’d really like to own. In this case, there is nothing you can do about it.
How to invest in index funds
While investing in an index fund does not follow any particular rules, but it would be easier for you if you go through the following procedures when intending to invest in index funds.
- Know which index the fund follows
Since indexing has become so popular (especially among ETFs) picking an index fund isn’t as easy as it used to be when there were fewer to choose from. Before you ultimately select an index fund, understand its underlying holdings and how the selection has behaved in the past. You also need to find out if the fund is specialized and specific. If it is, then you have to do your due diligence to make sure you understand what you are putting your money into. Specialized funds can be more “slippery” than mainstream index funds. You have to check and check again to make sure that the fund you are considering really does track an index.
- Choose where you’d like to buy your index fund
You can purchase an index fund directly from a mutual fund company or from a brokerage. There is an endless number of options where to buy index funds. Most discount brokerages offer them, so it’s a matter of checking out investing guides.
There are various things to consider when intending to buy index funds, and they include your fund selection, convenience of acquiring the index, trading costs and the commissions you are required to pay.
Fund selection: You have to decide of 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. You need to consider this carefully in order to make a good selection.
Convenience of acquiring the index: You must have to consider convenience when acquiring your index. You may have to find a single provider who can accommodate all your needs for the sake of ease. But if you require sophisticated stock research and screening tools, a discount broker that also sells the index funds you want may be better. All in all, ensure to pick a process that suits your needs.
Commission-free options: You also need to check if the brokers you choose offer no-transaction-fee mutual funds or commission-free ETFs. This is an important criterion that is used to rate discount brokers, and you should employ it too.
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.
- Learn about fund fees and tax effects
Low or reduced costs are one of the biggest selling points of index funds. These funds 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 as some can greatly surprise you by their costs. It is imperative that you figure out how much a potential index fund will cost you before you think of investing. All fee information are always listed on the broker’s website.
These costs you have to watch out for include:
Investment minimum: This is the minimum required to invest in a mutual fund and it can run as high as a few thousand dollars. Once you’ve crossed that threshold, you may only be allowed to add money in smaller increments.
Account minimum. This is different than the investment minimum, it is the minimum amount that is allowable in your account. Although a brokerage’s account minimum may be $0, but that doesn’t remove the investment minimum for a particular index fund.
Expense ratio. This is one of the main costs that are subtracted from each fund shareholder’s returns as a percentage of their overall investment. You can 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. Like the expense ratio, these taxes can take a bite out of investment returns: typically 0.3% of returns when invested in an index fund, according to a 2014 study by Vanguard founder John Bogle.
- Decide how much you’d like to invest
This part is an intensely personal decision. You’ll need to weigh how much you can invest against the fund’s minimums.
5. Make your investment
When you have considered all the above variables, you can now make your investment. Ensure that you invest in a portfolio that you are comfortable with. Investing in index funds is one of the simplest ways to grow your wealth over time. The key to investing in index funds, however, is to understand the index you are investing in and to get started sooner rather than later. So if you have any intention of investing in this fund, the time to start is now. The faster you can start investing your money for the long haul, the more time your money will have to grow on its own.
If your goal is building wealth for the future, index funds offer a great opportunity that can help you get started. The learning curve to dive into this type of investing isn’t too steep, and it’s easy to open an online brokerage account and start investing right away. With low operating costs and fees to match, index funds offer one of the most affordable ways to invest over the long-term.