An index fund is a cost-efficient investment vehicle that tracks a group of stocks, bonds, and other securities. The funds are developed by some of the leading asset managers in the world like Vanguard, Blackrock, and State Street. Indeed, the three firms have more than $15 trillion in assets under management. In this report, we will look at how you can invest in index funds and maximise your returns.
Differences between index funds, mutual funds, and exchange-traded funds (ETFs)
A common challenge among traders is on the main differences between index funds, mutual funds, and ETFs.
A mutual fund is a financial asset that tracks tens, hundreds, and even thousands of companies in the stock market. Some funds also invest in assets like bonds. These funds are usually managed by a fund manager, who charges an annual management fee, which can go up to 2%. The average expense ratio in a mutual fund is usually about 0.82%. Also, the goal of a mutual fund is to beat a benchmark.
An ETF, on the other hand, is a collection of financial assets that are then listed in an exchange like the New York Stock Exchange (NYSE) or the Nasdaq. The main benefit of an ETF against a mutual fund is its tradability. This simply means that you can buy and sell the fund at any time since it trades like stocks. Also, another advantage is that there is no minimum investment amount for ETFs.
An index fund is a type of mutual fund that is passively managed, meaning that it does not have a portfolio manager behind the scenes. Instead, its goal is to track the performance of the representative index. For example, the Vanguard 500 Index Fund Admiral Shares (VFAX) index tracks the companies in the S&P 500. It has a small expense ratio of just 0.04%. Therefore, it is correct to say that an index fund is a type of mutual fund, with the main difference being the type of management.
The biggest providers of index funds in the US are Vanguard, Blackrock, Fidelity, and Charles Schwab.
Advantages of investing in index funds
There are three primary reasons why people invest in index funds:
- Instant diversification – An index is made up of many companies, which can help you spread your wealth. Indeed, as shown below, your probability of losing money decreases depending on the assets that you own.
- Lower cost of investing – As mentioned above, the cost of investing in an index fund is usually negligible. The average fee for a mutual fund is usually about 0.15%.
- Tax efficiency – An index fund is a passively-managed fund unlike an ETF. As such, over time, the amount of tax you pay is reduced.
- Performance – An index fund tracks the overall index, which means that its performance, over a long period of time is assured.
Types of index funds
There are broadly four types of index funds that you can invest in. These are:
Domestic index funds
These are funds that invest in companies listed in the United States. A good example of these funds are the Fidelity 500 index fund, which tracks the S&P 500 index. There are also indexes that track growth, value, dividend, and companies based on their Environmental, Social, and Governance (ESG) characteristics. Examples of these funds are Fidelity Mid Cap Index Fund (FSMDX) and the Vanguard Total Stock Market Index.
International equity funds are ideal for investors who want to invest in overseas companies. For example, if you want to invest in the German equivalent of the Dow Jones, you can invest in a fund that tracks the DAX index.
Similarly, if you want to invest in European technology firms, you can invest in an index that tracks the biggest tech firms. Also, if you want to diversify by investing in all publicly-traded companies in Europe, you can find an index that does that.
Examples of these funds are Fidelity International Index Fund (FSPSX) and Vanguard Total International Stock Index Fund Investor Shares (VGTSX), among others.
Fixed Income index funds
Fixed income index funds track assets like treasury, municipal, and corporate bonds. Some track investment-grade bonds while others track junk bonds. Similarly, others track developed world bonds while others focus on emerging market bonds. Examples of these funds are Fidelity Inflation-Protected Bond Index Fund, Fidelity US Bond Index Fund, State Street Aggregate Bond Index Fund – Class A and Vanguard Total Bond Market Index Fund, among others.
Specialty index funds
These are funds designed to track specific financial assets. For example, the Fidelity Real Estate Index Fund tracks the total real estate companies and REITs that are listed in the US. Similarly, the Nasdaq composite index tracks all companies that are in the Nasdaq composite index.
Please note: While you can analyse index funds by yourself, a good option is to use Morningstar.com, which is the gold standard in rating bonds, ETFs, and other financial instruments. For example, the Fidelity Nasdaq Composite Index has five stars, which means that it is relatively safer than the Fidelity Real Estate Index that has just 2 stars.
Using Morningstar ratings to rank index funds
How to invest in index funds
Ideally, the process of investing in index funds is relatively easy. As mentioned above, a simple trick of the game is to check out the Morning star rating of the fund. However, you should not stop there because the system is not always accurate.
You should dig deeper before you invest. For example, before you invest in an index, take time and read its details, as provided in the website. Some of the details to consider are its historic performance and fees it charges.
On cost, you should always compare the costs involved. For example, Schwab, Vanguard, and Fidelity all offer a total market fund. While these funds are usually identical, they have different expense ratio. Fidelity has a ratio of 0.015% while Schwab and Vanguard have a ratio of 0.03% and 0.04%, respectively. Therefore, since costs can add up in a long time, you should always go with one with the lowest cost.
Please note. Unlike ETFs, you can only buy index funds with their respective companies. As such, you cannot invest in them using brokers like Robinhood.
Index funds are excellent cost-effective financial assets that help you take part in the financial market without doing much work. In most cases, these funds will never beat individual stocks. However, they will protect you by spreading your funds in multiple stocks. Also, we recommend that you invest in mutual funds for your long-term portfolio.