What are Index Funds? Full Guide to Investing

Index funds are popular with investors because they promise ownership of a variety of stocks, greater diversification, and lower risk – usually all for one low price.

For this reason, many investors, especially beginners, consider index funds to be superior investments over individual stocks.

They are an inexpensive and uncomplicated investment option. It could be the smartest, easiest investment you’ve ever made.

Everyone raves about index mutual funds, and for good reason: They’re an easy, convenient, diversified, and inexpensive way to invest in the stock market.

It is based on the Standard & Poor’s 500 Index (S&P 500) is among the best. The index includes hundreds of the largest, globally diversified American companies across all industries, making it a relatively low-risk way to invest in stocks.

This index is the very definition of the market and if you own a fund based on the index you will get the market return, historically around 10 percent a year. It is one of the most popular indexes.

In this writing, we shall examine what index funds are, how to invest in index funds and how to buy index funds.

What is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio that is built to match or track the components of a financial market index such as the Standard & Poor’s 500 Index (S&P 500).

An index mutual fund is designed to offer broad market exposure, low operating costs, and low portfolio turnover. These funds follow their benchmark index regardless of market conditions.

Index funds are generally considered to be ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401 (k) accounts.

Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life.

Rather than picking individual stocks to invest in, it makes more sense for the average investor to buy all of the S&P 500 companies for the low cost of an index fund.

What are the fees associated with index funds?

Index funds can come with different fees depending on the type of index fund:

  • Mutual Funds: Index funds sponsored by mutual fund companies can impose two types of fees: a sales fee and an expense ratio.

    A sales fee is just a commission on the purchase of the Fund and can appear on the purchase or sale or over time. Investors can usually avoid these by going to an investor-friendly fund company such as Vanguard, Schwab or Fidelity.

    An expense ratio is an ongoing fee paid to the fund company based on your fund assets. Usually these are charged daily and come out of the account seamlessly.
  • ETFs: Index funds sponsored by ETF companies (many of which also operate mutual funds) only charge one type of fee, an expense ratio. It works just like a mutual fund, with a tiny portion that is seamlessly withdrawn every day you hold the fund.

    ETFs have become increasingly popular lately because they help investors avoid some of the higher fees associated with mutual funds.

    ETFs are also becoming increasingly popular because they offer other important advantages over mutual funds

Best Index Funds for 2021

The following list includes S&P 500 index funds from a variety of companies and includes some of the most affordable funds that trade in the public markets.

With such an index fund, the cost is one of the most important drivers of your total return.

1. Fidelity ZERO Large Cap Index (FNILX)

The Fidelity ZERO Large Cap Index mutual fund is part of the mutual fund’s foray into no-expense-ratio mutual funds, hence the nickname ZERO.

The fund does not officially track the S&P 500 – technically it follows the Fidelity U.S. Large Cap Index – but the difference is academic.

The real difference is that investor-friendly Fidelity doesn’t have to pay a license fee to use the S&P name, which reduces the cost for investors.

Expense ratio: 0 percent. This means that every $10,000 invested would cost $0 annually.

2. Vanguard S&P 500 ETF (VOO)

As the name suggests, the Vanguard S&P 500 tracks the S&P 500 index and is one of the largest funds on the market with hundreds of billions in the fund.

This ETF started trading in 2010 and is backed by Vanguard, one of the powerhouses in the fund industry.

Expense ratio: 0.03 percent. That means every $10,000 invested would cost $3 annually.

3. SPDR S&P 500 ETF Trust (SPY)

The SPDR S&P 500 ETF is the forefather of ETFs, which was founded in 1993. He helped start the wave of ETF investment that has become so popular today.

With hundreds of billions in the fund, it’s one of the most popular ETFs. The fund is sponsored by State Street Global Advisors – another industry heavyweight – and tracks the S&P 500.

Expense ratio: 0.09 percent. That means every $10,000 invested would cost $9 annually.

4. iShares Core S&P 500 ETF (IVV)

The iShares Core S&P 500 ETF is a fund sponsored by one of the largest mutual funds, BlackRock. This iShares fund is one of the largest ETFs and, like these other large funds, tracks the S&P 500.

Launched in 2000, this fund is another long-standing player that has closely followed the index over time.

Expense ratio: 0.03 percent. That means every $10,000 invested would cost $3 annually.

5. Schwab S&P 500 Index Fund (SWPPX)

With tens of billions of dollars in assets, the Schwab S&P 500 Index Fund is on the smaller side of the heavyweights on this list, but that’s not really a problem for investors.

This mutual fund has a strong balance sheet dating back to 1997 and is sponsored by Charles Schwab, one of the most respected names in the industry.

Schwab is particularly known for its focus on investor-friendly products, as the wafer-thin expense ratio of this fund shows.

Expense ratio: 0.02 percent. That means every $ 10,000 invested would cost $2 annually.

The S&P 500 index fund continues to be one of the most popular index funds. S&P 500 funds offer good returns over time, are diversified, and are a relatively low-risk way to invest in stocks.

  • Attractive Returns – Like all stocks, the S&P 500 fluctuates. But over time, the index has returned about 10 percent annually.

    That doesn’t mean that index funds make money every year, but over long periods of time, that was the average return.
  • Diversification – Investors like index funds because they offer instant diversification. With one purchase, investors can own a wide variety of companies.

    One stock of an index fund based on the S&P 500 offers ownership in hundreds of companies.
  • Lower risk – because of the diversification, investing in an index fund is less risky than owning a few individual stocks.

    That doesn’t mean you can’t lose money or that they’re as safe as a CD, for example, but the index usually fluctuates much less than a single stock.
  • Low Cost – Index Funds can charge very little for these benefits with a low expense ratio. With larger funds, you might pay $3 to $10 a year for every $10,000 you invest.

    In fact, a fund (listed above) doesn’t charge you an expense ratio at all. With index funds, cost is one of the most important drivers of your total return.

While some funds like the S&P 500 index fund allow you to own companies across industries, others only own specific industry, country, or even an investment style (e.g. dividend stocks).

How to invest in an index fund

It’s surprisingly easy to invest in an index fund, but know what you’re investing in, not just buy random funds that you know little about.

1. Select an index fund to invest in

Your first step is figuring out what to invest in. While an S&P 500 index fund is the most popular index fund, it also exists for different industries, countries, and even investment styles.

So you need to think about what exactly you want to invest in and why it might present opportunities:

  • Location: take into account the geographic location of the investments. A broad index like the S&P 500 owns American companies, while other index funds might focus on a narrower location (France) or an equally broad location (Asia-Pacific).

  • Company: In which sector or sectors does the index fund invest? Is it going to be invested in pharmaceutical companies that make new drugs, or maybe in technology companies? Some funds specialize in certain industries and avoid others.

  • Market opportunity: What opportunities does the index fund offer? Is the fund buying drug companies because they’re making the next blockbuster drug or because they’re cash cows paying dividends? Some funds invest in high yielding stocks while others look for high growth stocks.

You should carefully examine what the fund is investing in so that you have an idea of ​​what you actually own.

Sometimes the names of an index fund can be misleading. However, you can check the holdings of the index to see exactly what is in the fund.

Despite the wide variety of choices, you may only need to invest in one. His investment royalty Warren Buffett has said that the average investor only needs to invest in a broad stock index to be properly diversified.

2. Decide which index fund you want to buy

After you find a fund that you like, you can look at other factors that make it suitable for your portfolio. The fund’s expenses are huge factors that can make – or cost – you tens of thousands of dollars over time.

Once you’ve decided on an index, it’s time to buy the appropriate index fund. Often times this boils down to the cost.

Low cost is one of the biggest selling points for index funds. They are inexpensive to operate because they are automated to track changes in value in an index. However, don’t assume that all index mutual funds are cheap.

Although they are not actively managed by a team of well-paid analysts, they do have administrative costs. These costs are deducted from the income of each fund shareholder as a percentage of their total investment.

Two funds can have the same investment objective – like the replica of the S&P 500 – but have management costs that can vary widely.

Those fractions of percentage points might not be a big deal, but the slightest charge inflation can have a massive impact on your long-term investment returns. Typically, the larger the fund, the lower the fees.

  • Minimum investment: The minimum required to invest in a mutual fund can be up to a few thousand dollars. Once you’ve crossed that threshold, most funds allow investors to add money in smaller increments.
  • Minimum account: This is different from the minimum investment volume. Although a broker’s minimum account may be $0 (common for clients opening a traditional or Roth IRA), it does not override the minimum investment size for a particular index fund.
  • Expense ratio: This is one of the main charges deducted from each fund shareholder’s income as a percentage of their total investment. You can find the expense ratio in the prospectus for the mutual fund or when you call up an offer from a mutual fund on a finance page.

In context, the average annual expense ratio was 0.09% for equity index funds and 0.07% for bond index funds, compared to 0.82% for actively managed equity funds and 0.58% for actively managed bond funds, according to a 2016 report by the Investment Company Institute.

  • Tax-cost ratio: In addition to paying fees, possession of the fund may incur capital gains taxes if held outside of tax-privileged accounts such as a 401 (k) or IRA.

As an expense ratio, these taxes can reduce investment returns: according to a 2014 study by Vanguard founder John Bogle, typically 0.3% of returns when invested in an index fund.

3. Purchase your index fund

Now that you’ve decided which fund will fit your portfolio, it’s time for the easy part – actually buying the fund. You can either buy directly from the mutual fund company or through a broker.

But it’s usually easier to buy a mutual fund through a broker. The same goes for Exchange Traded Funds (ETFs), which are like mini-mutual funds that trade like stocks all day.

When deciding to buy an index fund, consider the following:

  • Fund selection: Would you like to purchase index funds from different fund families? The large mutual fund companies run some of their competitors’ funds, but choices can be more limited than what is available in a discount brokerage lineup.
  • Convenience: Find a single provider that can meet all of your needs. For example, if you only want to invest in mutual funds (or even a mix of funds and stocks), a mutual fund company can serve as your investment hub.

    However, if you need sophisticated stock research and screening tools, a discount broker who also sells the index funds you want might be better.
  • Trading costs: If the commission or transaction fee is not waived, consider how much a broker or mutual fund company will charge to buy or sell the index fund. Mutual fund commissions are higher than stock trading, around $20 or more, compared to less than $10 per trade for stocks and ETFs.
  • Impact investing: Some index funds track benchmarks that target companies with more women in leadership positions, global companies in the clean energy universe, or high ESG (environmental, social and governance) ratings.
  • Commission-free options: Do you offer mutual funds with no transaction fees or commission-free ETFs? This is an important criterion by which we rate discount brokers. (It’s worth choosing from Charles Schwab, E-Trade, Fidelity and TD Ameritrade.)

Can an index fund investor lose it all?

Investing money in market-based assets like stocks or bonds means investors could lose everything if the company or government issuing the security gets into serious trouble.

The situation is somewhat different for index funds, however, as they are often so diversified.

An index fund typically owns at least dozens of stocks and can potentially own hundreds of them, which means it is highly diversified.

In a stock index fund, for example, every stock would have to go to zero so that the index fund and thus the investor loses everything. So while it is theoretically possible to lose everything, it doesn’t happen with standard funds.

However, an index fund can underperform and lose money for years depending on what it is invested in. But the likelihood that an index fund will lose everything is very slim.

What is a good expense ratio?

Mutual funds and ETFs have one of the cheapest average expense ratios, and the number also depends on whether they are investing in bonds or stocks.

In 2020, the average stock index mutual fund averaged 0.06 percent (on an asset-weighted basis), or $6 for every $10,000 invested. The average stock index ETF averages 0.18 percent asset-weighted, or $18 for every $10,000 invested.

Index funds are usually much cheaper than average funds. Compare the above numbers to the average equity fund (on an asset-weighted basis) that calculates 0.54 percent or the average equity ETF that calculates 0.18 percent.

While the ETF expense ratio is the same in either case, mutual fund costs tend to be higher. Many mutual funds are not index funds and charge higher fees to pay the higher expenses of their investment management teams.

Anything below average should therefore be viewed as a good expense ratio. However, it’s important to keep those costs in view and realize that the difference between a 0.10 percent expense ratio and 0.05 percent is only $5 per year for every $10,000.

Still, there is no reason to pay more for an index fund that tracks the same index.

Is now a good time to buy index funds?

If you are buying a stock index fund, or almost any broadly diversified equity fund like an S&P 500 fund, this may be a good time to buy. That’s because over time, as the economy grows and corporate profits rise, the market tends to rise.

In this regard, time is your best friend as it enables you to top up your cash and let your money make money. However, tightly diversified index funds (e.g. funds that focus on one industry) can do poorly for years.

However, investors need to think long-term, and experts recommend investing money in the market on a regular basis.

You benefit from the dollar-cost average and lower your risk. Strong investment discipline can help you make money in the market over time.

Conclusion

These are some of the best S&P 500 index funds out there, offering investors the chance to own the S&P 500 stocks at a low cost while enjoying the benefits of diversification and lower risk.

Given these advantages, it’s no surprise that these are some of the largest funds out there.

References

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