Index Funds - All You Need To Know
Index funds are great for investors who want to spend little time investing, while still allowing their investments to grow at a considerable rate! In this article we will cover what an index fund is, how it competes with more active investments, and how you can get started today!
What Is an Index Fund?
An Index fund could be said to be a mutual fund that aims to recreate the composition of a financial market index such as the S&P 500. Since an index fund is made to follow a specific underlying market index, management is not needed to the same extent as with actively managed funds. That makes it possible for index funds to lower their operating expenses, and provide broad market coverage at a low price, in turn enabling them to closely replicate the performance of the underlying index, without management fees taking the lion’s share of the profits!
Due to their broad market allocation and low operating fees, index funds are ideal for those who want to place their savings in a safe and rewarding investment form. That is why many choose to invest in index funds for their retirement (IRA) and 401(k)s accounts.
Warren Buffet indeed was right when he referred to index funds as “safe heavens” and recommended average investors not to pick individual stocks, but invest in a passively managed index fund. Actually, Buffet has gone as far as saying that index funds are the best investments most Americans can make! Historically, this has been a rewarding strategy, that will most likely continue to generate wealth for coming generations.
Index Funds VS stocks
Many new investors seek to understand whether index funds, other mutual funds, or stocks is something for them. Most often the answer will be index funds, but depending on how much work the aspiring investor is ready to put in, it could vary! Index funds have many great advantages, but investing in stocks or actively managed mutual funds could hold greater profit potential for skilled investors!
Benefits of Investing in Stocks
As a stock picker or investor, you have the opportunity of constructing your own portfolio and decide what should be part of it and not. You may read up on investment strategies, learn fundamental and technical analysis, and become a skilled investor that outperforms the market in the long run. There is a lot to read and learn, and for those who are willing to invest time in their investment career, stock picking and active investing hold excellent profit potential. Small investors sometimes also have the option of buying stocks that a large mutual fund cannot enter because of their sheer size. This could provide the individual stock investor with investment opportunities that can’t be utilized by a large mutual fund.
Stocks also enable investors to choose their risk profile. More aggressive investors might buy smaller and riskier companies, while more conservative investors might go for the biggest and most stable ones. As an active investor, you might also choose not to include individual stocks that you don’t believe in. That’s not possible with index funds, since the underlying index predetermines their composition!
Benefits of Index Funds
Many new investors are not very knowledgable about stocks, index funds and investments. There mere sight of an individual share with all its performance metrics might seem overwhelming. For such investors, index funds hold the significant advantage of requiring nothing from their owner. You just buy and forget about it (apart from taxes). Your investment will always be up to date, and there will be no need to screen markets for news or events. Everything such as portfolio turnover is taken care of for you!
Index funds also have the benefit of giving you high levels of diversification. The typical investor might hold 15-20 different shares in varying market sectors. With an index fund, depending on which one it is, you might have your risk spread across as many as 500 stocks! That is a considerable difference that will minimize risk in a way that is hard to accomplish through individual stock picking. Besides, if your capital is too small, you will most likely pay a large portion of your returns in commission! That is not the case with index funds that generally have very low fees.
Index Funds vs Actively Managed Mutual Funds
A mutual fund, in short, is an index fund that doesn’t track a market index. These are often actively managed funds that use different strategies to try to beat the passively managed index funds.
Of course, active management comes at a cost. Many mutual funds have expense ratios of over 1% or more, which must be considered carefully when investing. Fees can quickly eat into your profits, and the more that is charged for active management, the more the fund has to perform for it to be worth the high costs. In many cases, the fees together with weak performance make index funds the better choice of the two!
Usually, cheap index funds cost around 0.2-0.5% while managed funds typically cost somewhere between 1-2.5%. Having a low expense ratio is paramount! Especially in long term investments that will grow with the help of compound interest!
But shouldn’t an Actively Managed Fund Be Better?
The management of a mutual fund requires fund managers to make daily and sometimes hourly investment decisions. With that much work put into understanding where the market is heading and trying to profit from it, you would expect an actively managed fund to outperform the average index fund.
Well, that is not the case. History shows that beating passive market return, in other words, indexes, is extremely difficult. Some fund managers might succeed in one or two years, but in longer periods of time, nearly all fail. According to S%P Dow Indices data, 90% of US funds that were actively managed failed to outperform the S%P500 in the years from 2001 to 2016. In other words, an index fund would have outperformed 90% of actively managed funds in that period!
That’s not to say that actively managed funds are always inferior to index funds. There are some actively managed funds that have managed to perform very well against their benchmark index, even including their higher expense ratios! However, for the average investor who doesn’t spend much time on research, index funds is an easy yet powerful form of investment that has done well over long periods of time.
Why Do People Invest In Actively Managed Mutual Funds?
Since a cheap index fund will beat a more expensive actively managed mutual fund in most cases, this is a relevant question to ask. Mutual funds very seldom manage to perform better than the typical index fund, despite that the actively managed mutual fund being run by very knowledgable stock investors. Here are some factors to why people might choose to buy an index fund instead of an actively managed fund.
- Exposure of good years. When actively managed funds or index funds have good years, they naturally catch the attention of investors. This is especially true with mutual funds. In years when a fund manages to deliver good results, investors will most likely believe that his mutual fund is likely to be much better than other competing index funds. While this could very well be true, in most cases it’s just pure luck that some funds have managed to perform better than other funds.
- Playing the lottery- Humans like the prospect of big money. When mutual funds beat their benchmark index people assume that that very mutual fund will continue to beat other index funds also in the future. As readers of this article know, that assumption is false.
- Overconfidence. Many investors believe that they better than anybody else can pick investments, in this case, mutual funds, that will perform better than the typical index fund. Of course, skilled investors exist, but most people will not manage to choose a mutual fund that performs better than any average index fund.
It’s important to remember that far from everybody who chooses a mutual fund over index funds is misguided! There certainly could be situations where investors can be confident of their investment in actively managed funds as well!
Depending on where you live in the world, index funds are taxed differently. For example, in the US, stockholders of a mutual fund are taxed yearly on all portfolio turnover in the mutual fund itself, even if they haven’t sold anything on their own account. In other countries, stockholders might only be taxed when they sell their position in the mutual fund, in the same way as US company shareholders only pay taxes when they sell their shares positions.
Of course, the advantages of index funds also vary by country. However, if we were to generalize, index funds have one great advantage. That is their low portfolio turnover, compared to actively managed mutual funds and stock investing.
Why Is Low Portfolio Turnover Good?
When active investors close positions, in most countries, they are taxed on their capital gains. Many stock pickers rearrange their portfolio of stocks once in a while and incur taxes almost every year.
The big benefit of index funds is that its stocks are sold relatively seldom compared to other mutual funds. Many of the shares have been part of the fund’s investment portfolio for many years, and nothing is paid in tax before it’s sold. In that way, what had been paid in taxes, instead remains in the fund and is subject to compound interest!
Let’s make a quick calculation so that everybody is with us on this one!
Example of Index fund Tax Efficiency
If our mutual fund holds the same stock for 3 years and makes on average 10% in annual returns on a 100$ investment, after 3 years, it’s worth 100$ * (1.1^3 ) = 133.1$. With a tax rate of 30%, we would need to pay 9.93$ in taxes. Left for us, after taxes have been paid, is 130$-9.93$= 123.17$.
Now, insinuate that our mutual fund rotates all stocks every year and buys new ones. That means that you would be taxed on your annual 10% gain three times; once every year. For you left to reinvest after taxes would be 100$*1.07= 107$ after the first year and 107$*1.07=114.49$ after the second year. By the end of the third year, after taxes have been paid, you will have 114.49$*1.07=122.5$ left.
As you see, there is a difference. In the first example, we got a return of 23.17$ and in the second it was slightly lower at 22.5$. It’s not much, but it will certainly grow with time due to compound interest.
How to Choose An Index Fund
After having read this far, we’re quite sure that you’re convinced that it’s an index fund you should invest in. So how do you do?
1. Choice of broker
First of all, you should choose a broker to buy your mutual fund from. Make sure to investigate the strengths and weaknesses of different competitors by reading forums and searching the web. You should ask questions like:
- Have there been any problems with the platform?
- How is the customer service?
- Is my broker secure? Not all brokers guarantee your money in case of bankruptcy.
- Does the broker offer the mutual fund/funds that I want to invest in?
3. Choose an Index –
Choose an index that you want your index fund to track.
Here is a list of the most common indexes in the US:
- The Standard & Poor’s 500 index (S&P500)
- the Russell 2000 index
- the Wilshire 5000 Total Market Index
- the MSCI EAFE index
- the Dow Jones Industrial Average index
- the Barclays Capital U.S. Aggregate Bond Index
- the Nasdaq Composite index
Why not spread your risk by buying more than one index fund? Buying index funds that track different indexes is a great way of diversifying your portfolio!
2. Compare Index Fund Fees and Expenses
As we’ve covered before, minimizing fees and commissions is critical when choosing an index fund. Unfortunately, this is something many investors never fully understand. Do some research, and you will soon find some good mutual funds that will save you a lot of money in the long run!
3. Buy Your Index Fund
Now it’s time to make your first purchase. That is if you know what mutual fund to buy! If you don’t, look below where we list some good index fund options!
However, if you know what index fund to invest in we recommend you to start slowly and invest a small amount every month. Before you know it, with a little help from compound interest, you will have gathered a considerable amount of money,
List of Different US Index Funds
Here comes a short list with index funds that have low expense ratios. Take a careful look at the first index fund in the list. It has an expense ratio of 0 %! How do you beat that?
Final Investment Tips
So, you have bought your first index fund and are eager to see your account grow. That’s great, and we would like to end this article by giving you some general investment tips!
- Only Invest Money That You Can Afford to Lose- Index funds is one of the safest investment forms out there, but risk cannot be eliminated completely!
- Be Perseverant- The long-term trend of equities is positive, but on the way, there will be bumps. Don’t invest in index funds if you know that you will need your money soon.
- Be Realistic With Your Expectations – Don’t expect your investment to rise every year. You will have losing years, and returns will vary greatly! It’s possible that one year your mutual fund might lose 20% of its value, only to surge some 30% short thereafter!
- Don’t panic in case of market crashes- Market crashes are inevitable and part of investing in equities. Once you’re struck by it, don’t panic! Keep calm! The market will soon return to its normal state and your index funds will rise again!