If you want to invest in a financial asset with low operating costs, broad market or sector exposure, and lower taxes, an index fund may be right for you. You will find that you can use your brokerage or the mutual fund itself if you research how to invest in index funds. If you’re having a hard time choosing investments for your investment portfolio, you can invest in an index fund instead 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 indexes that can mimic funds. 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 index funds held 40% of the total $25 trillion invested across all funds at the end of 2020. That’s an increase from less than 20% of a smaller total in 2010. Figures like that make investing in index funds more than worth it. Also, US ETFs that are index trackers have now outperformed index funds.
An index fund is a mutual fund or exchange-traded fund (ETF) that holds a portfolio of securities that tracks the performance of one of many market indices. Index funds are perfect for beginning investors and are widely used as core holdings in retirement accounts such as 401(k)s and individual retirement accounts (IRAs). They provide exposure to the broad market or to a specific market sector, depending on your interest. They offer lower taxes than some investments because they have less portfolio turnover and lower taxes as a result. Operating costs are usually low because index funds are passively managed. As the fund tracks a market index there is no need for active management as the index fund moves with that market index.
If you are ready to be matched with local advisors who can help you achieve your financial goals, start now.
There is one important caveat to choosing an index fund. Index funds are very good investments if their time horizon is far out. If you’re approaching 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 can track a broad market index, such as the Standard and Poor’s 500 Index. In other words, these funds try to mirror the performance of that index. Index funds can also track the performance of different market sectors. The rationale behind index funds is to try to match the risk and return of the market index it tracks. The theory is that an investment that tracks all securities in the broader market will always yield higher returns than a single investment.
The Standard and Poor’s 500 is a market index that tracks the broad market and has several index funds that track 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 contains more of the largest securities in the market and less of small company stocks. 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 if the tech sector takes a hit, so will this index. Therefore, 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, check out their stock or fund screening tools. You should be able to enter variables related to the index funds that pique your interest and come away with a list of options. For example, you could invest in a total market fund that has a low expense ratio and is passively managed. You may want a lower initial investment. Perhaps you have ideas about what company stocks you would like to see in the index fund or ETF of your choice.
To compare two such funds, consider the Wilshire 5000 Index Investment Fund, for example. It is an investment fund that owns approximately 3,500 US stocks weighted by market capitalization. It has an initial investment of $1,000 and an expense ratio of 0.63%. The one-year return, as of April 2021, of 48.88%. About 25% of the fund consists of shares of technology companies.
For example, another total market fund is the Vanguard Total Stock Market Index Admiral Shares fund. While it is a much larger fund than the Wilshire 5000, it is also heavily weighted in favor of technology company stocks. It has an initial investment of $3,000 and a very low expense ratio of 0.04%. The 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 of primary importance, you can 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 will find many variables to consider when choosing 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 can save on both income tax and fund costs. You save income tax because, because the fund is not actively managed, there is less portfolio turnover. Managers don’t buy and sell securities nearly as often because the fund tracks the performance of fairly stable market indices. Expense ratios are lower for funds or ETFs that are passively managed, as there are no large research staff and fewer managers. Fewer people have to pay.
You can also get better exposure to the broad market by tracking one of the total market indices. Even if you only own a portion of each security in the index, it’s common to see better returns than if you tried to manage the securities in a portfolio yourself. You don’t have a chance to try and time the market.
Index funds and ETFs may be the way to go if your time horizon is five years or more, but actively man
aged funds often win in the short term. However, if you have no interest in managing a portfolio and you are a buy-and-hold investor, index funds are a good choice.
As for the downsides of index funds, investing in index funds is unlikely to beat the market, since you are essentially following the performance of the market. However, you can win something close to a market return. Perhaps the biggest drawback of index funds is that they are vulnerable to market swings, pullbacks and crashes.
It comes down to
If you’re an investor looking to invest economically, without much help or involvement, and if you’re 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 entire market to smaller ones that track the performance of one market sector or even specialized financial instruments such as currencies. Choosing the right index fund for your risk tolerance, interests, time horizon and investment goals is just as important as choosing a portfolio of stocks or bonds.
Tips for investing
Even when investing in index funds, you can probably benefit from the insights of a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free to decide which one is best 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 related to 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 when you retire? Let SmartAsset’s retirement calculator help you determine your potential tax liability.
Photo credit: ©iStock.com/anyaberkut, ©iStock.com/Laurence Dutton, ©iStock.com/Credit:DKosig
The post How to Invest in Index Funds appeared first on SmartAsset Blog.