If you would like to invest in a financial asset with low operating costs, exposure to the broad market or a market sector and lower taxes, an index fund might be for you. You will find that you can use your brokerage or the mutual fund company itself if you explore how to invest in index funds. If you are struggling to choose investments for your investment portfolio, you can instead invest in an index fund and get a piece of the many companies that make up the broader financial markets. Here’s what you need to know.
There are many indexes that funds can be designed to mimic. Work with a financial advisor to find the ones that best fit your goals, timeline and risk profile.
What Is an Index Fund?
Index funds have become some of the most popular fund investments. The Investment Company Institute reports that at the end of 2020, index funds were 40% of the total $25 trillion invested in all funds. That’s up from under 20% of a smaller total in 2010. Those kinds of numbers make index fund investing more than worthy of a look. Also, American ETFs that are index trackers have now exceeded index mutual funds.
An index fund is either a mutual fund or an exchange-traded fund (ETF) that holds a portfolio of securities that track the performance of one of the many market indexes. Index funds are perfect for beginning investors and are used extensively as core holdings in retirement accounts like 401(k)s and individual retirement accounts (IRAs). They offer exposure to either the broad market or to a specific market sector depending on your interest. They provide lower taxes than some investments since they have less portfolio turnover and lower taxes as a result. Operating costs tend to be low because index funds are passively managed. Since the fund is tracking a market index, there is no need for active management since the index fund moves with that market index.
There is an important caveat when trying to choose an index fund. Index funds are very good investments if their time horizon is a long way out. If you’re nearing retirement and looking for an investment, you probably don’t want to choose an index fund, whether mutual or exchange-traded, when your time horizon is less than five years.
Index funds may track a broad market index like the Standard and Poor’s 500 Index. In other words, these funds are trying to mirror the performance of that index. Index funds can also track the performance of a variety of market sectors. The rationale behind index funds is to try to match the risk and return of whatever market index it is tracking. The theory is that an investment tracking all the securities in the broader market will always make a return that is superior to a single investment.
The Standard and Poor’s 500 is a market index that tracks the broad market and it has several index funds tracking its performance. This index is the most popular of all indexes. The securities included in the S & P 500 index are weighted by their market capitalization. In other words, the index holds more of the largest securities in the market and less of the small companies’ stocks. The top stocks in the S&P 500 fund are Amazon, Facebook, Apple, Alphabet and other similar stocks. In other words, it is heavy on technology stocks so when the technology sector takes a hit, so does this index. This is why investors have to choose their index funds carefully to meet their investment goals and time horizon.
How to Invest in Index Funds
If you want to invest in one or more index funds or ETFs, you can do so through your brokerage account. Your brokerage must offer both mutual funds and ETFs. If you have an online brokerage account, take a look at their stock or fund screening tools. You should be able to put in variables concerning the index funds that spark your interest and come away with a list of options. For example, you may want to invest in a total market fund that has a low expense ratio and is passively managed. Maybe you want a lower initial investment. You may have ideas about which company stocks you would like to see within the index fund or ETF you choose.
If you want to compare two such funds, examples might be the Wilshire 5000 Index Investment Fund. It is a mutual fund that holds around 3,500 U.S.-based stocks weighted by market capitalization. It has a $1,000 initial investment and an expense ratio of 0.63%. Its one-year return, as of April 2021, of 48.88%. About 25% of the fund is composed of technology company stock.
Another total market fund, for example, is the Vanguard Total Stock Market Index Admiral Shares fund. Although a much larger fund than the Wilshire 5000, it is also heavily weighted in favor of technology company stocks. It has a $3,000 initial investment and a very low expense ratio of 0.04%. Its one-year return was 51.05%. So, you have two very similar firms, except for their size and minimum initial investment. If the initial investment is of primary concern, then you might choose the Wilshire 5000 fund. However, if the expense ratio is more important to you, you would want to choose the Vanguard fund. As you compare more and more funds, you find many variables that you should consider to choose a fund or ETF to meet your own risk tolerance, time horizon and investment goals.
Pros and Cons of Passively Managed Index Funds
One of the benefits of passive management is that you save money. You may save on income taxes as well as on fund expenses. You save on income taxes because, since the fund is not actively managed, there is less portfolio turnover. Managers aren’t buying and selling securities nearly as often since the fund is tracking the performance of reasonably stable market indexes. Expense ratios are lower for funds or ETFs that are passively managed since there isn’t a large research staff and fewer managers. There are fewer people to pay.
You can also get better exposure to the broad market by tracking one of the total market indexes. Even if you own just a piece of every security in the index, it often happens that you make a better return than if you try to manage the securities in a portfolio yourself. You don’t have the chance to try to time the market.
Index funds and ETFs may be the best choice if your time horizon is five years or more, but in the short term, actively managed funds often win. However, if you don’t have an interest in managing a portfolio and you are a buy-and-hold investor, index funds are a good bet.
As far as cons of index funds, it’s unlikely that you are going to beat the market if you invest in index funds since you’re actually tracking the performance of the market. However, you may gain something approximating a market return. Perhaps the biggest downside of index funds is that they are vulnerable to market swings, pullbacks and crashes.
The Bottom Line
If you are an investor who wants to invest economically, without much assistance or involvement, and if you are a long-term or buy-and-hold investor then one or more of the many index funds may be for you. They have many advantages and few disadvantages if you are not an active trader. Index funds range from large ones that track the total market all the way down to smaller ones that track the performance of one market sector or even such specialized financial instruments as currencies. Choosing the right index fund for your risk tolerance, interests, time horizon and investment goals is just as important as if you were choosing a portfolio of stocks or bonds.
Tips on Investing
- Even with index fund investing, you can likely benefit from the insights of a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Success in investing is partly about your portfolio’s asset allocation. SmartAsset has an asset allocation calculator that will assist you in picking the right asset allocation for you.
- How much in taxes will you pay in retirement? Let SmartAsset’s retirement calculator help you determine your potential tax liability.
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