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Understanding Index Investing

Index investing with exchange-traded funds (ETFs) and mutual funds gets a lot of positive press, and justly so. At their best, index funds provide a low-cost option for investors to monitor popular stock and bond market indexes. Index funds, in many cases, outperform many actively managed mutual funds.

It’s tempting to believe developing an index fund investing strategy is easy. However, ETF and mutual fund providers have developed several new index products as a response to the increased popularity index investing has seen. As a result, it’s essential to understand what an index fund is and how to purchase them, along with some of the top index funds.

Key Takeaways:

  • Index funds track the movements of numerous markets, investment strategies, and sectors on a daily basis to help gauge the overall health and performance of the markets they are following.
  • When an index investor purchases an index fund, they get a well-rounded selection of multiple stocks in one package, meaning they don’t need to purchase these stocks individually.
  • When deciding where to purchase index funds, it’s essential to consider fund selection, convenience, trading costs, and commission-free options.
  • Index funds are made up of assets and securities sharing similar factors, including company size, geography, business sector, asset type, and marketing opportunities.
  • While the S&P 500 is one of the most well-known indexes, there are many others to consider, including Direxion Work From Home ETF, Fidelity Sustainability Bond Index Fund, Global X Millennials Thematic ETF, iShares Russell 2000 ETF, and Vanguard 500 Index Fund.
  • Costs and fees to consider when index investing include investment minimum, account minimum, expense ratio, and tax-cost ratio.

What Is an Index Fund?

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An index fund is an ETF or mutual fund that tracks a specific market index. There are thousands of indexes tracking the movements of several investment strategies, markets, and sectors daily. These indexes help determine the overall performance and health of the markets they track. For example, the U.S. Global Jets Index monitors the airline industry worldwide as a sector index, while the Dow Jones Industrial Average, a broad market index, is made up of 30 blue-chip stocks. Indexes can also act as benchmarks for the market as a way of measuring its performance.

Index funds are passively managed. This means the securities included in the index rarely change and are usually held to minimize costs and maximize returns. Mutual funds, however, and some ETFs are actively managed. This means fund managers can trade any securities in their market segment as little or as often as they feel necessary in an effort to beat the benchmark.

Index Investing Strategy

When index investors purchase an index fund, they receive a well-rounded collection of several securities in a single package without having to buy each stock individually.

Since index funds hold all investments in a specific index, management fees are usually low. This results in higher returns for individual index investors. I’m not an adviser, so it’s crucial to perform additional research on your own to make the best decisions for your portfolio. Index funds are simple to purchase following these easy steps:

Decide Where to Buy

An index investor can purchase index funds directly from a brokerage or mutual fund company. Other important things to consider when selecting where to purchase an index fund include:

  • Fund Selection: Are you looking to buy index funds from several fund families? The larger mutual fund companies may carry some funds from their competition. However, the selection might be more limited than what you may find in the lineup of a discount broker.
  • Convenience: Find one provider able to meet all your needs. For instance, if you’re only looking to invest in mutual funds or a mix of stocks and funds, a mutual fund company might be a good fit as your investment home. However, if you’re looking for more sophisticated screen tools and stock research, a discount broker who currently sells the index fund you’re wanting may be a better fit.
  • Trading Costs: If the transaction fee or commission isn’t waived, it’s crucial to consider how much a fund company or broker charges to buy and sell index funds. Mutual fund commissions are usually around $20 or more compared to under $10 per trade for ETFs and stocks.
  • Commission-Free Options: A vital component when selecting a discount broker is if they offer commission-free ETFs or no-transaction-fee mutual funds.

Pick an Index

Index mutual funds monitor several indexes composed of various assets and securities that are selected based on:

  • Capitalization and Company Size: Index funds tracking small, medium, or large companies, also known as a small-, mid-, or large-cap indexes.
  • Geography: Index funds focusing on stocks trading on foreign exchanges or combinations of international exchanges.
  • Industry or business sector: Index funds focusing on various industries or business sectors, including health-related companies, technology, and consumer goods.
  • Kind of Asset: Index funds tracking foreign and domestic cash, commodities, and bonds.
  • Market Opportunities: Other new but growing sectors available for investing.

The S&P 500 (Standard & Poor 500) index is one of the most popular and well-known indexes. It tracks 500 large U.S.-based companies representing a wide array of industries. Of course, the S&P 500 isn’t the only index available index investors; other index funds include:

  • Direxion Work From Home ETF (WFH): U.S. businesses that benefit from individuals working from home.
  • Fidelity Sustainability Bond Index Fund (FNDSX): Bonds that meet governance, social, and environmental criteria.
  • Global X Millennials Thematic ETF (MILN): U.S. businesses benefiting from the spending habits of the millennial generation.
  • iShares Russell 2000 ETF (IWM): Two thousand U.S. small-cap stocks.
  • Vanguard 500 Index Fund (VFIAX): Five hundred of the biggest businesses in the U.S.

Check Investment Minimum and Other Costs

Minimal costs are some of index funds’ best selling points. They’re inexpensive to operate since they’re set up to automatically follow value shifts of an index. However, don’t make the mistake of assuming all index mutual funds are cheap.

While they aren’t actively managed by a group of analysts, they do have administrative costs that need to be covered. Every fund shareholder pays a percentage of their overall investment to cover administrative costs.

Even though two index funds can have the same investment goal, such as monitoring the S&P 500, their costs can vary drastically. While a fraction of a percentage point might not seem like a big deal, long-term investments can take a significant hit from the slightest fee inflation. Usually, the larger the fund, the lesser the fees. Essential costs to consider include:

  • Investment Minimum: The investment minimum is exactly what it sounds like: Investors need to contribute a base amount to a mutual fund. This amount can be as high as a couple of thousand dollars. After this threshold is met, many funds allow index investors to add funds in small increments.
  • Account Minimum: The investment minimum is different than the account minimum. While a brokerage may have an account minimum of $0, which common for individuals opening a Roth or traditional IRA, there may still be an investment minimum for specific index funds.
  • Expense Ratio: This is one of the main costs to consider when deciding on an index fund strategy. This cost is subtracted as a percentage of an overall investment from the returns of each index investor. Investors can find the expense ratio in the prospectus of the mutual fund or by calling up a quote on a financial site of a mutual fund. For example, the average annual expense ratio is around 0.07% for a bond index fund and 0.09% for a stock index fund compared to 0.58% for an actively managed bond fund and 0.82% for an actively managed stock fund.
  • Tax-Cost Ratio: Owning an index fund might also trigger capital gains taxes if it’s held outside tax-advantaged accounts such as an IRA or a 401(k).

Over the last 10 years, mutual funds, index funds, and ETFs have consistently done better than actively managed funds. As always, it’s essential to carefully review any index fund or ETF before investing since they aren’t all alike. Generally speaking, though, index funds can be outstanding investments.