How to Invest in Index Funds?

Updated on Feb 6, 2020 at 12:25 pm UTC by Adedamola Bada · 11 min read
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Photo: QuoteInspector
Photo: QuoteInspector

Figuring out the best assets for your investment portfolio can be a difficult thing to do. Investing in an index fund comes as one of the best solutions, especially when you’re a new investor.

Index funds allow for diversification of assets for the consumer’s investment portfolio; this means the investor gets to make an investment across several industries and companies instead of assessing individual stocks.

Investment in index funds is not limited to only stock market trading but includes a wide array of financial tools that enables you to make investments in just any asset class with value. Index funds are a great investment option for people who are looking to make long-term investments that grow wealth over time, as it covers for retirement and future living expenses.

Investing your money with an online stock broker isn’t a bad choice, but it doesn’t open you up to the numerous opportunities and potential that an index fund possesses. The index fund has a lot of tools and resources that come with the lowest fees possible, which provides exposure to your desired marketplace.

What Is an Index Fund?

An index fund is a branch of mutual fund that makes use of the securities under its watch to either match or track a precise market index. It doesn’t require constant monitoring, making it an excellent choice for portfolio diversification with the promise of stable returns.

This is possible because index funds are not in competition with the market. They don’t try to get the upper hand in the market or to earn above-market averages. Instead, its game plan is to acquire stocks belonging to different companies listed on a particular index to mirror the index’s performance in all its entirety.

Index funds have been found to be very advantageous to investors because it helps mitigate risks for their portfolios, as it is less likely for an index to experience volatility unlike with individual stocks.

Generally speaking, an index is made up of bonds or stocks, and there are rules put in place which govern their operation. Index funds usually imitate market indexes like the U.S. Stock Market, U.S. Bond Market, S&P 500, and others.

An index fund does not incur a lot of expenses because its operating cost is low. Also, it provides a broader scope of the market as well as low portfolio turnover rates for investors. They are subject to specific rules and standards which cannot be altered regardless of the condition of the markets.

Index fund investments entail a form of passive investing in which the investor doesn’t do much but has access to a broad range of assets within a specific market.

What are the Benefits of Index Funds?

There are so many benefits associated with investments made in an index fund. An individual investor can aim to get better returns by investing in an index fund, which saves time and effort that would be spent on researching investments and managing the investment portfolio.

Index funds are much easier to acquire and hold since they always match the index’s returns, which helps in controlling loss aversion as well as other factors that can pose a problem to the investor when trying to manage the portfolio of investment assets.

Taxes incurred by index funds are much lower relative to that of traditional mutual funds. The stocks held by index funds usually result in low turnover rates as the index fund manages to maintain its low turnover ratio, and there’s not a lot of buying and selling involved. Capital gains taxes and expense ratios are also minimized in index funds.

Index funds are the cheapest way to invest without having to pay a commission, and this makes them relatively inexpensive. Also, investors have access to diversified assets with strong long-term returns as well as passive forms of investing.

What is the Difference between Index Funds and Mutual Funds?

Both mutual funds and index funds diversify your assets across hundreds of stocks, but index funds can track a specific index. An investor could become a trader with a mutual fund that is just a shadow of a broader market, the index fund.

Also, mutual funds charge a fee of up to 2% on the investors, and this is not dependent on how the mutual fund is doing. Whereas, the index fund doesn’t charge much in fees to the investor.

While actively managed mutual funds employ professional personnel to generate market-beating performance, the index funds aim to create returns that are equal to the returns of an index without fees. This makes for a wide gap in performance between the index funds and mutual funds.

Some might argue that actively managed mutual funds can surpass stock indexes by picking good investments, which create better returns, but factoring in the fees and the probability of achieving market-beating returns, an average investor would be better off investing in an index fund over the mutual funds.

Another key difference between the index fund and mutual fund is that index funds are mostly passive investing with passive instruments, while the investment of a mutual fund is mostly active instruments. Also, index funds track the performance of the index, which acts as a benchmark, but mutual funds track the performance of multiple stocks on which they track the performance of the holdings.

There is a lock-in period feature for index funds, while mutual funds are mostly open-ended funds, which make the index funds close-ended. If this factor greatly matters to the investor, they can choose to go with the mutual funds.

How to Start Investing in Index Funds?

An investor looking to start making investments in index funds simply has to have an account with a stockbroker, have a Registered Investment Adviser, or have an index fund firm. The best thing would be to go with the firms since they make the whole process automated.

The top criteria for firms which are leading index fund and Exchange-Traded Funds (ETFs) provider are Vanguard, State Street, Global and BlackRock are the leading market service providers that offer a wide range of index funds and ETFs.

The fees differ with each platform you choose to invest in. And since index funds are less actively managed, you would have to start the investing process by choosing a Robo Advisor which is a computerized investment service which makes use of algorithms, based on an investor’s risk tolerance and financial objectives, to create a portfolio which can be used to invest in capital in index funds or ETFs.

The investor can then make investments in the index funds, which are dominated by the leading companies like the Financial Times Stock Exchange (FTSE) or the Standard and Poor 500 (S&P 500), with large and mid-sized company stocks.

Take note of the market index you wish to draw from, and since index funds mirror specific market indexes, there are options to choose from. Although, the costs of investing in index funds differ with the investment platform of choice and will be insignificant since the Robo Advisors make irrelevant the use of real managers, making it a budget-friendly option.

An international index fund can be combined with a domestic index fund by making it 50/50 if you want maximum diversification, but you might want to rebalance back to an original index portfolio structure to reduce the diversification since markets tend to go up and down differently. Although, if you make use of a global index fund, the rebalancing won’t be needed seeing as it combines both the U.S. and international markets.

The next thing to do would be to make a decision on the right amount of stocks against bonds, and this would be done just as you would choose if you were still an active investor. The right proportions of a high-grade bond index fund and index equity fund will help in making a low-cost portfolio for the investor.

With experience on basic index funds, the investor may decide to expect high-returns long-term prospects for a specific kind of investment or nation.

What are the Best Index Funds to Invest In?

The choice of the index funds to buy matters seeing as all aren’t going to perform the same way as time goes on. Since some top index funds are buy-and-hold-oriented, they can serve as long-term investments. Here are some of the top index funds to go with:

iShares Core S&P 500 ETF (IVV)

This is a large-capacity equity index fund that incurs a fee of 0.04%, which can be accessed by its parent, the asset manager BlackRock, Inc. BlackRock, Inc. offers low-cost fees on its products such as the Core-branded ETFs, which includes the S&P 500-tracking iShares Core S&P 500 ETF.

The IVV charges seven basis points and is one of the cheapest recommendations in existence.

VanEck Vectors Preferred Securities ex Financials ETF (PFXF)

This Preferred Stock index fund has a low expense ratio of 4% with a 5.4% yield and low volatility, which is a great combination. Preferred Stocks take preference over common stock dividends because of the dividends on them, and they must be paid before common stock dividends are.

Preferred stocks are assets which are geared towards high income, and demands that companies pay all missed dividends in arrears before resuming the dividends to common shares.

iShares Core S&P Mid-Cap ETF (IVV)

The performance of this index fund is very high, seeing as the IJH holds a 15-year record win over the IVV. This is because the mid-cap companies generally feature a stronger long-term growth potential relative to large-cap companies and possess more financial stability with more access to capital and managerial experience than small-cap companies.

They incur an expense ratio of 0.07%, which is slightly higher than that of the IVV.

SPDR S&P Bank ETF (KBE)

This index fund operates with industrial stocks, banking to be precise. KBE has gained a growth of 25% due to the wide-spread belief that Donald Trump will reduce Wall Street regulations. The KBE is a focused collection of multiple banks, including national brands and smaller ones.

They incur an expense ratio of 0.35%, and bank stocks have actually done very well in 2019.

Top Traditional Brokers

These can be chosen at the expense of using a Robo Advisor, and they provide a platform where investors can make decisions with more control over their investments. Here are some of the top online traditional brokers:

Fidelity

This broker charges the lowest of a fee for an index fund or ETF at a rate of 0.00%, meaning they don’t charge at all on funds. Although they have a limited range of options to choose from, and they are all zero expense ratio index funds and ETFs.

Charles Schwab

They incur a low fee of 0.02% for an index fund or ETF and receive zero commission per trade made with Charles Schwab funds. They offer over twenty varieties of Schwab Index funds and ETFs.

Vanguard

This is a top-tier broker leading in low-cost index investing, offering a wide range of funds. They charge a 0.04% fee for an ETF or index fund and also receive a zero commission for trades made with Vanguard funds.

Top Robo-Advisors

These automated financial advisers go a long way in choosing the right investments for the investor; they simply create a portfolio based on some factors like the level of returns expected, risk tolerance, and the time frame between when the money is invested and when it’s needed.

Betterment

This is known as the oldest Robo Advisor in existence and performance, with over $13.5 billion worth of assets in its management. The accounts at Betterment come with annual fees ranging from 0.25% to 0.4%, with the difference being that there are standard accounts and premium accounts.

Wealthfront

This is another good Robo Advisor option for investors, it has over $10 billion worth of assets in its management, and the majority of its accounts charge a low rate of 0.25% for annual management fees. They focus on building portfolios of low-cost ETFs and also offer direct indexing for accounts by mimicking ETFs, which is great for tax management purposes.

There are several others, including the Personal Capital Robo Advisor, the Robo Advisor product from Charles Schwab, the Schwab Intelligent Portfolios, Ellevest, M1 Finance, and several others.

Conclusion

For a newbie investor looking to trade in index funds, be sure to weigh your options and preferences before making decisions on investments. The right index fund, stocks to trade, and management platform will go a long way in helping secure good returns on investments made.

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