- In the investment world, an index is a tool that tracks the performance of an asset class or a sector of an asset class.
- Index-linked investing is a way to passively and cost-effectively invest in an index. Oftentimes, this is accomplished via share-based vehicles known as index funds.
- Investing in index funds makes sense for investors who want to establish a diversified portfolio in an effortless and inexpensive way.
- Investing in index funds does not make sense for opportunistic investors that value tactical maneuvers and are comfortable paying for active asset management.
Before we delve into how to invest in index funds and how they can be incorporated into your personal finance strategy, let’s take a step back and discuss the concept of an index. An index is a numeric measure of something. In the investment world, it is a tool that tracks the performance of an asset class or sector of an asset class, such as U.S. common stocks, U.S. large-cap common stocks or U.S. small-cap common stocks.
As outlined below, there are three interrelated applications of an investment index:
- An index can be used to monitor market performance and gauge economic sentiment. If widely referenced, it can help retail and institutional investors, economists and businesspeople speak the same financial language.
- An index can be used to benchmark the performance of actively managed investments, providing a means to determine whether the returns produced justify the costs incurred.
- An index can facilitate index-linked investing, which is also known as passive investing. This is a widely popular, hands-off and cost-effective way to replicate the returns of an index, rather than trying to outperform it via active management.
One of the most common ways to conduct index-linked investing is through the ownership of index funds, which brings us to the focus of this guide – how to invest in index funds. Below, we break it down into four steps.
1. Determine Your Investment Goals
Before investing in an index fund, you need to identify and prioritize your investment objectives. Most investors are focused on some combination of ensuring liquidity, preserving capital, generating income, fueling growth and fostering diversification.
To facilitate the process, ask yourself the following questions:
- What is the purpose of your investment?
- How long is your investing time horizon?
- How comfortable are you with volatility?
- Can you afford to lose any of your money in exchange for the prospect of accumulating wealth?
Articulating your investment objectives and tolerance for risk is fundamental to making prudent investments. I recommend working with a fiduciary financial advisor, as they can help you assess things in a holistic fashion.
2. Research Indexes and Pick One To Track
Next, it’s time to research available indexes and select one, or a few, that track assets exhibiting characteristics that align with your investment objectives and tolerance for risk. In doing so it is important to consider the following factors:
- Asset Type: There are indexes that track stocks, bonds, real estate assets, cryptocurrencies and commodities.
- Geography: Some indexes have an international focus. Others focus on specific continents, countries or regions.
- Company Size: Company size is an important factor to consider, especially for indexes that track stocks or bonds. Some indexes focus on small companies, medium-sized companies or large companies.
- Business Sector and Industry: Oftentimes, indexes that track stocks and bonds focus on specific sectors or industries, such as consumer goods, health care, technology or energy.
3. Choose a Fund That Tracks Your Chosen Index
Once you’ve narrowed down a suitable index (or a few), you need to select a corresponding index fund to purchase them. There are a couple of ways to do this.
The most straightforward approach is to utilize a brokerage firm, which is likely to have robust search tools designed to help you make investment decisions. If your brokerage firm’s technology is lacking, there are several websites, like MarketWatch.com and Portfoliovisualizer.com that can help.
When comparing similar funds, cost is often the most important differentiating factor. That said, it’s smart to make sure any fund of interest has a long track record, significant assets under management and low-tracking error with respect to the underlying index.
4. Buy Shares of the Index Fund
The final step of the process involves buying shares of the index fund(s) you selected. To do so, you’ll need a brokerage account. Today, most brokerage firms enable trades online or via the phone. Some even have storefronts for in-person transactions.
Whichever form you choose, to place a buy order, you need to know the appropriate fund ticker symbol(s) and the amount of money you wish to invest. You may need to also determine the number of shares you can buy. The brokerage firm can help you do this and execute your transaction(s).
After making your purchase(s), be sure to periodically monitor performance. Make sure your holdings are fulfilling your investment objectives.
Be open to modifying or liquidating your holdings if your financial situation or investment goals change. However, do not make any hasty sales due to short-term market fluctuations.
Is Investing in Index Funds Right for You?
Investing in index funds is an increasingly popular way to gain diversified exposure to financial markets of interest – without expending a lot of time and energy. They could be a sensible addition to your investment portfolio, but it’s up to you and your financial advisor to make that determination.
Investing in index funds makes sense for hands-off investors that are not comfortable paying fees for active investment management. For them, diversified investment exposure can be achieved via an index fund or collection of index funds – without the burden of administrative complexity and excessive costs.
Investing in index funds does not make sense for opportunistic investors that embrace tactical maneuvers and are comfortable paying for active management. In some instances, this approach can yield superior returns. However, it’s important to note that very few asset managers have demonstrated the ability to consistently produce net-of-fee returns that exceed those generated by index funds.
One of the most attractive aspects of index funds is their inexpensive nature. Unlike actively managed mutual funds, index funds do not employ costly teams of research analysts and asset managers trying to outperform the market. Index funds seek to merely match the performance of their designated indexes.
Usually, this can be done in a very efficient manner, but costs vary, depending on the index fund provider and the index being tracked. Generally, large fund providers and widely tracked indexes are associated with lower costs than small fund providers and niche indexes.
The ongoing annual cost of an index fund is represented by its expense ratio, which is expressed as a percentage of the market value of your investment. The expense ratio includes the fund’s management fee, administrative costs and other charges – which are collectively referred to as the fund’s “operating expenses.”
The most inexpensive index funds have expense ratios between 0.01% and 0.15%. Some niche index funds, which track assets like commodities, have expense ratios as high as 0.85%. Incidentally, for actively managed mutual funds, it is not unusual to see expense ratios in the range of 1.00% to 2.00%.
If an index fund has an expense ratio of 0.07%, that means you’ll pay $7 of annual fees for every $10,000 invested. The charges will be automatically deducted from the returns generated by the fund.
Pros and Cons
Index funds are popular investment vehicles held by both retail and institutional investors. Their advantages are notable, but they are not without certain disadvantages.
- Returns track performance of specified index
- Involves minimal administrative effort
- Offers potential for immediate diversification
- Generally, very low-cost
- Generally, highly liquid
- Poorly designed funds exhibit high tracking error
- No opportunity to outperform the market
- Niche funds are not diversified
- Niche funds can be costly
- Niche funds can be illiquid
Common Indexes To Consider
Many indexes are designed to track the performance of an entire asset class, such as stocks, bonds, real estate or commodities. However, many indexes are designed to track an aspect of an asset class, oftentimes, based on geographic location and/or industry sector.
- S&P 500 Index
- The S&P 500 Index tracks the performance of the common stock issuances of the 500 largest companies in the U.S. These companies are commonly referred to as “blue chips.”
- NASDAQ Composite Index
- The NASDAQ Composite Index tracks the performance of the common stock issuances of over 3,000 technology-oriented companies in the U.S.
- MSCI ACWI Index
- The MSCI ACWI Index tracks the stock issuances of large-cap and mid-cap stocks across 23 developed markets and 24 emerging markets. It is a proxy for the universe of global, publicly-traded stocks.
- Bloomberg Barclays U.S. Aggregate Bond Index
- The Bloomberg Barclays U.S. Aggregate Bond Index, which is commonly referred to as the Barclays Agg, tracks the investment grade, dollar-denominated, fixed-rate taxable bond market in the U.S. The index includes Treasuries and government-related securities, corporate securities, residential and commercial mortgage-backed securities and other, asset-backed securities.
- S&P GSCI Commodity Index
- The S&P GSCI Commodity Index is a broad-based index that serves as a proxy for the universe of global commodities.
Frequently Asked Questions about Index Funds
An index fund is formed when an investment company establishes a vehicle comprised of assets that mirror the assets in an index, such as the S&P 500. Then, depending on how the various assets perform, the fund is adjusted accordingly.
In the S&P 500 example, this means buying more of the stock of outperforming companies and selling the stock of underperforming companies. The result is an investment return that matches the performance of the S&P 500, minus a very modest management fee.
Yes. It is possible to lose money by investing in an index fund. The possibility is highest for index funds comprised of volatile assets, such as technology stocks and commodities. Index funds comprised of less volatile assets, such as investment-grade bonds, are comparatively stable.
Index funds and exchange-traded funds (ETFs) are very similar; both are pooled investment vehicles that offer diversified access to an asset or a group of assets. Most index funds are structured as open-ended funds, but some closed-ended funds exist. An open-ended fund trades at prices determined by the fund’s net asset value at the end of each trading day, while a closed-ended fund trades throughout the day at fluctuating market prices. Whereas, all ETFs trade throughout the day at fluctuating market prices.
Editor Malori Malone contributed to this article.