If you want to invest in a financial asset with low operating costs, exposure to a broad market or 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 are exploring how to invest in index funds. If you find it difficult to choose investments for your investment portfolio, you can instead invest in an index fund and get a share of the many companies that make up the broader financial markets. Here’s what you need to know.
There are many cues 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 one of the most popular fund investments. The Investment Company Institute reports that at the end of 2020, index funds accounted for 40% of the total $25 trillion invested in all funds. That’s up from less than 20% of a smaller total in 2010. These kinds of numbers make investing in index funds more than worthwhile. Additionally, US ETFs that are index trackers have now overtaken 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 several stock market indices. Index funds are great for newbie investors and are widely used as base holdings in retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs). They offer broad market exposure or a specific market sector depending on your interests. They offer lower taxes than some investments because they have less portfolio turnover and therefore lower taxes. Operating costs tend to be low because index funds are passively managed. Since the fund tracks a market index, active management is not necessary since the index fund moves with this market index.
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There is an important caveat when trying to choose an index fund. Index funds are very good investments if their time horizon is long. If you’re nearing retirement and looking for an investment, you probably won’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 attempt to track the performance of that index. Index funds can also track the performance of various market sectors. The whole point of index funds is to try to match the risk and return of whatever market index they track. The theory is that an investment that tracks all stocks in the broader market will always generate a higher return than a single investment.
The Standard and Poor’s 500 is a market index that tracks the overall market and it has several index funds that track its performance. This index is the most popular of all indexes. Securities included in the S&P 500 Index are weighted by market capitalization. In other words, the index holds more of the largest stocks in the market and less of the stocks of smaller companies. The top stocks in the S&P 500 fund are Amazon, Facebook, Apple, Alphabet and other similar stocks. In other words, it’s heavy on tech stocks, so when the tech sector takes a hit, so does this index. That’s why investors should 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 should offer both mutual funds and ETFs. If you have an online brokerage account, take a look at their stock or fund selection tools. You should be able to add variables regarding the index funds that pique your interest and come away with a list of options. For example, you might 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 the stocks of companies you would like to see in the index fund or ETF you choose.
If you want to compare two such funds, examples might be the Wilshire 5000 Index Investment Fund. This is a mutual fund that holds approximately 3,500 US stocks weighted by market capitalization. It has an initial investment of $1,000 and an expense ratio of 0.63%. Its one-year return, in April 2021, of 48.88%. About 25% of the fund is made up of shares of technology companies.
Another total market fund, for example, is the Admiral Shares fund from Vanguard Total Stock Market Index. Although it is a much larger fund than the Wilshire 5000, it is also heavily weighted towards stocks of technology companies. It has an initial investment of $3,000 and a very low expense ratio of 0.04%. Its one-year return was 51.05%. So you have two very similar businesses except for their size and minimum initial investment. If the initial investment is your main concern, you can choose the Wilshire 5000 fund. However, if the expense ratio is more important to you, you may want to choose the Vanguard fund. As you compare more and more funds, you find many variables you should consider when choosing a fund or ETF based on 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 can save on income tax as well as fund expenses. You save on income tax because, since the fund is not actively managed, there is less portfolio turnover. The managers don’t buy and sell stocks as often since the fund tracks the performance of reasonably stable market indices. Expense ratios are lower for passively managed funds or ETFs since there are not many research staff and fewer managers. There are fewer people to pay.
You can also get better exposure to the broader market by following one of the total stock indices. Even if you only own a portion of each stock in the index, you often get a better return than if you tried to manage the stocks in a portfolio yourself. You don’t get 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’re not interested in managing a portfolio and are a long-term investor, index funds are a good bet.
As for the disadvantages of index funds, you are unlikely to beat the market if you invest in index funds since you are actually tracking the performance of the market. However, you can earn something close to a market return. Perhaps the biggest downside of index funds is that they are vulnerable to market swings, pullbacks and crashes.
If you are an investor who wants to invest economically, without too much assistance or involvement, and if you are a long-term or buy-and-hold investor, one or more of the many index funds may be right 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 broad market to smaller ones that track the performance of a sector of the market or even of specialized financial instruments such as currencies. Choosing the right index fund based on your risk tolerance, interests, time horizon and investment goals is just as important as choosing a stock or bond portfolio.
Tips for investing
Even with index funds, you can probably benefit from the advice of a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
The success of an investment depends in part on the asset allocation of your portfolio. SmartAsset has an asset allocation calculator that will help you choose the right asset allocation for you.
How much tax will you pay in retirement? Let SmartAsset’s retirement calculator help you determine your potential tax liability.
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