Disclaimer: Nothing in this article should ever be considered advice, research or an invitation to buy or sell securities. I am not a financial advisor.
Investing is one of the most effective ways to build long-term wealth.
However, between the investment jargon, conflicting opinions and fear of losing our hard-earned money, it’s easy to put investing on the backburner.
Enter index funds – a “set it and forget it” investment class that has exploded in popularity over the years.
Whether you are a seasoned investor or just starting out on your investing journey, index investing offers a lot of unique benefits relative to other investing strategies.
In this ‘Quick Start Guide’ we’ll be covering the basics of index investing including:
- What is an Index Fund and How Do They Work?
- How to Invest in Index Funds (Examples, Costs, Investment Types)
With that being said, let’s dive in.
What is an Index Fund and How Do They Work?
An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to replicate the performance of a specific market index, such as the S&P 500 or Dow Jones Industrial Average.
This is achieved by the index fund’s underlying assets mirroring the composition and weighting of the particular index that it is tracking.
As an example, an S&P 500 index fund will contain positions in the 500 companies making up the S&P 500 index. Furthermore, the specific investments made into each company is based on the size of the company relative to the other companies within the index.
In other words, larger companies will be a larger percentage of the index while smaller companies will make up a smaller percentage of the index.
As of this writing, the Top 5 holdings of an S&P 500 index fund would be:
Because an index represents a basket of investments vs holding individual stocks, they are often an easier way to add broad market/exposure and diversification to any portfolio.
With that being said, because index funds are designed to match the performance of the market index they are tracking, they will never outperform the market. Depending on the index however, that’s not necessarily a bad thing.
As an example, the S&P 500 has had a historic annualized average return of 11.88%. Not bad.
Due to their diversification characteristics and great rate-of-returns, index funds have become a popular investing strategy for those who prefer a more hands-off approach to long-term investing.
How to Invest in Index Funds
When it comes to investing in index funds, there are three primary considerations:
- Which index do we want to track?
- How do we want to invest in the index?
- How much does an index fund cost?
Which Index Do We Want To Track?
The first consideration with index investing is deciding which index that we want to track.
There is no right or wrong answer. Which index we choose to track is up to our individual investing preferences, risk tolerances and investment goals.
With that being said, here is a non-exhaustive list of common market indices and what they track:
How Do We Want To Invest In An Index?
Our next consideration with index investing is deciding whether to invest via a Mutual Fund or ETF.
Similar to before, which type of investment class we choose is a matter of preference.
Mutual Funds and ETFs are both investment funds that represent a basket of investments aligned with a specific investing strategy (in this case a market index). While Mutual Funds and ETFs are very similar, they do differ in some key respects, primarily:
- Mutual Funds only trade once a day while ETFs trade throughout the day
- Mutual Funds can require investment minimums whereas investing in ETFs only require paying the share price
- Most brokerage accounts don’t allow for automatic ETF investments due to price volatility
- Mutual Funds and ETFs can have different expense ratios
Using the same market indices as before, below is a non-exhaustive list of different Mutual Funds and ETFs that track each market index:
Note: When looking at the different investment options for a specific index, the historical performance between each fund should be nearly identical. As a result, it’s extremely important to make sure that we are actively comparing the costs between each fund (where they are more likely to differ).
Speaking of costs…
Common Costs Associated with Index Funds
Because index funds are designed to match the performance of an index vs outperforming it, they will generally have much lower costs compared to actively-managed funds.
However, the individual costs between funds can still widely vary between different index funds. As we previously alluded to, it’s important to evaluate ALL costs associated with owning a particular index fund.
Some common costs to look out for include:
We should do our due diligence in order to understand the complete cost structure associated with any index fund that we are considering purchasing.
That is because much like our money compounds over time, so do investment fees. As a result, lower overall costs will translate to us retaining a larger portion of our investment returns over time.
Final Thoughts
It is extremely hard to consistently beat the market over the long-term.
So, if you can’t beat them, join them.
In fact, most experts agree that “equity investors can expect to do better by holding a well-diversified, low-fee, passive index fund than by holding a few stocks.” As a result, index funds can provide investors with a more disciplined and systemic approach to achieve their financial goals.
Thank you for reading!
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
