How To Invest in Index Funds
What are index funds & how do they work?
Index Funds are highly popular these days, and with good reason. They offer an easy, low-cost way to invest in the stock market and allow for a diversified, hands-off investment strategy.
Index funds are investment vehicles that track a market index such as the S&P 500. They mirror the companies and performance of an index, ensuring that the index fund earns similar returns as the index. Thanks to their passive investment approach, index funds have lower fees than actively managed funds, thus often generating higher returns on the invested capital. Due to their popularity, nowadays there is a wide choice of index funds available. Plus, they are easy to invest in and can be bought in a few simple steps.
For investors wanting to further diversify or cover specific industries and countries, it can make sense to purchase several different index funds. This allows for a broad investment diversification while at the same time taking into account personal preferences and expectations for the future.
Well managed index funds generate the same returns as the index they are mirroring minus the fees (~0.5%) charged by the fund issuer. Index funds are not traded on stock exchanges. Buying and selling is only possible once a day via the fund issuer. Once commissioned, your broker will handle the index fund’s purchase or sale for you.
Index funds vs Mutual funds vs ETFs?
How do index funds differ from mutual funds and ETFs? Below you find a brief overview.
Index: Indices track the performance of a basket of shares or bonds. Their goal is to provide a simplified market overview over a specific market segment. Shares represented in an index usually have a common denominator, such as jurisdiction, industry, or market capitalization. The most common stock market indices are the S&P 500 (500 largest US companies), the Nasdaq 100 (100 largest US tech companies) and the Dow Jones Industrial Average (30 largest US companies from all industries).
Mutual funds: A Mutual Fund is a pool of capital collected from multiple investors to invest in a pool of diversified financial assets. Mutual funds are operated by professional fund managers who attempt to earn profits according to the objectives stated in the prospectus. Due to the mostly active portfolio management, these funds usually have higher management fees than Index Funds and ETFs.
Read the guide: How To Invest In Mutual Funds
Index funds: An index fund is the combination of the two concepts, which is why they sometimes are also called index mutual funds. Instead of hiring an expensive fund manager to pick investments, index funds simply replicate an index. Fund managers only have to rebalance the fund’s stocks holdings to mirror the index as close as possible. This reduces costs and eliminates the risk of significantly underperforming the markets.
ETFs: ETF stands for Exchange Traded Funds. They can be bought and sold on an ongoing basis during trading hours. Like index funds, EFTs are passively managed, charge low fees and often track market indices as well. Due to their higher liquidity and the ability to resell them to other investors instead of having to sell them back to the index fund, the number of ETFs available has sharply increased over recent years.
Read the guide: How To Invest In ETFs
How are they taxed?
In most jurisdictions, realized capital gains are taxable. That also means that capital gains are only taxable once the financial instruments have been sold. As index funds replicate the holdings of an index, they don’t trade in and out of securities often. Therefore, they produce less taxable events than active fund managers. For investors holding index funds long term, this results in significant tax savings.
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Pros & cons of index fund investing
Index funds are seen as a conversative investment, which offers relatively high safety due to their diversified investment approach. Nevertheless, index funds do not protect investors from short term market volatility and crashes. Following, we look at pros & cons of index funds investments.
- Diversification: Index funds include a multitude of companies, sometimes from different industries and even multiple countries. This allows for strong diversification, which reduces risk.
- Low costs: Due to index funds’ passive investment approach, the absence of active fund managers and low numbers of taxable trades, the costs for investors are comparably low.
- Steady growth: Index funds let you participate in the steady overall growth of an industry or economy, which in the past generated good returns over the years.
- No big gains: Index funds will never outperform their respective market. As indices mostly include the dominant players in an industry, a country or market, index funds offset upwards and downwards outliers, preventing investors from seizing investment opportunities in outperforming companies.
- Lack of flexibility: Index funds only allow investments into the whole index. Poorly performing companies cannot be excluded, outperformers cannot be weighted more in the portfolio.
- Crashes and corrections: Index funds do not protect investors from market crashes and corrections. As they mirror the market, investors are participating in all the market swings.
How to buy index funds in 4 steps
Step 1: Decide on the right investment account
Depending on the jurisdiction you are living in, in general, when starting to invest in index funds, it is advised to first max out tax-privileged accounts. Many countries encourage retirement planning through tax benefits. As most retirement accounts allow investments in index funds, taking advantage of the offered tax benefits for long-term investing and saving is a smart way to start investing. Additional funds can then be deposited in a personal brokerage account.
Step 2: Select a broker
In general, when planning to invest in index funds, there are two types of online brokers available. Traditional online brokers and Robo-Advisors.
Most banks provide their customers with access to the financial markets. For smaller investors, their fees can be hefty though. It therefore makes sense to choose a broker with low or no fees, such as Fidelity, Robinhood and Schwabb. They have simple user interfaces and provide access to the most common financial instruments such as stocks, bonds and index funds.
Robo Advisors take care of your investment in an objective and automated way based on algorithms. They take the hassle out of investing by trading for you, while still being cheaper than traditional asset managers. In most cases, Robo Advisors ask you a set of questions to determine your investment preferences and will then automatically select suitable investments. Many Fintech companies and large brokers offer Robo Advisory services to their customers. Do your own research to find a Robo Advisor you would like to work with. Examples are Betterment and Vanguard.
Step 3: Choose which fund to invest in
When choosing an index fund to invest in, there are two decisions you have to make.
First: What index would you like to invest in? There are dozens of indexes around the world for various industries, continents, countries and fields. Would you like to be as broadly invested as possible? US only? Emerging markets? Or in a specific field? A Google search will reveal the indices matching your choice.
Second: Once an index has been decided on, an index fund has to be found. Searching for your index in your brokerage account displays the available options. Usually, there are multiple companies that offer index funds for a specific index. A quick comparison of the fees can save you money.
Examples of index funds:
- Schwab S&P 500 Index Fund – A straightforward, low-cost fund with no investment minimum which seeks to track the total return of the S&P 500 Index.
- Vanguard Total Stock Market Index Fund – Is best suited for moderately to highly risk-tolerant investors seeking low-cost exposure to the U.S. stock market.
- Fidelity Contrafund -The Fidelity Contrafund is a growth and value stock fund that focuses on generating capital gains rather than income.
Step 4: Monitoring your portfolio
Investing in index funds allows for a hands-off investment approach and daily monitoring is not necessary. Nevertheless, a quarterly portfolio check is advised to stay up to date with the latest market developments and to have a feel for your investment performance.
Depending on your investment goals, it can make sense to set up monthly deposits into your brokerage account, which then can be invested too. Such an approach is called dollar cost averaging. This forms a continuous and disciplined investing habit, which is especially important for retirement accounts.
Investing in index funds is an easy and low-effort way to invest your money. It does neither require much knowledge about the financial markets nor the overall economy nor individual companies. As such index funds are well suited for investors wanting to participate in the overall long term economic growth without having to go through the trouble of doing their own research or daily checking on their investments.
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