Investment Basics: Start with an Index Fund

For beginners, investing in an index fund is a great way to get in the game. You don’t have to try and pick your own stocks. An index fund means you’re investing in the whole index. Why is that a good thing?

Because an index fund is a pre-determined group of assets – i.e, stocks, bonds, commodities – all with one investment. The stocks in the fund are pre-determined by the market they are indexing. There’s no need for a fund manager. The fund buys and holds assets that align to the index itself. You don’t have to know a lot about individual stocks or bonds, you evaluate the performance of the index as a whole.

Quick Facts

  • An index fund is a passive investment strategy. All that’s required is you invest your money.
  • Because there is no “fund manager” Index funds have lower fees. Some funds charge nothing.
  • An index fund is aligned to the overall market for risk and return. It assumes the totality of the market produces better returns than any single stock or security.

Index funds are built on a specialized mutual funds or Exchange-Traded Funds (EFT) or a combination of both. Both represent pooled money from multiple investors. An EFT account can be traded on the stock market unlike a mutual fund.

Index funds are designed for long-term investment. They hold their assets, as opposed to buying and selling securities. This is the opposite of an actively managed fund that tends to try and outperform the market. The strategy of an index fund is to perform in alignment with the index.

How Does an Index Fund Work?

An index fund is a portfolio of investments aligned to market indices. Simply put, an index fund is group of securities, lumped together by a set of common set of criteria. An index fund is designed to mimic the performance of a financial market index, like the Dow or the NASDAQ.

The familiar example of an index fund is the S&P 500. It mimics the market by grouping the top 500 publicly traded companies into one index. The fund is sometimes considered to be on par with the market itself. They include Apple, Berkshire Hathaway, Alphabet, Tesla, Facebook and JP Morgan Financial, to name a few. Over $11.2 trillion is invested through the fund – the portfolio representing close to 80% of the U.S. stock market’s value.

The S&P 500 places a value on its portfolio using market capitalization, or market cap. Market cap is a calculation that multiplies the number of shares outstanding by the current price of a share. While share prices can fluctuate, the number of outstanding shares drives market cap.

A company like Apple, with an average of 19+ billion outstanding shares, could have a low share price but have a high market cap. A company with a higher share price, but fewer outstanding shares would have a lower market cap. In the S&P 500, the top ten companies make up 28% of the market capitalization.

Risks of index funds

Every investment has risk and index funds are no different. Specific to an index funds, here is short list of risks:

  • Lack of Responsiveness: An index fund may be slower to respond to share  within the fund’s portfolio than an actively managed fund.
  • Tracking Confusion: Some index funds may only invest in a portion of the securities in the index. Because of that, the index fund may not align to its index. Investors feel mislead when the fund underperforms the index.
  • Fees and Expenses.The costs of administering a fund can take a sizable chunk of an investor’s return. Trading costs can also detract from the anticipated value.

Types of Index Funds

These funds are always aligned to an index and there are plenty of types to pick from:

Company size or capitalization

The S&P 500 is a large cap index fund, but there are small and mid-size cap funds out there. The market capitalization for mid-cap companies ranges from $2 to $10 billion. They tend to be companies that operate in a high growth industry and are looking to expand. They carry a higher risk than large cap fund. Find a list of mid-cap funds here.

Small cap funds track companies with a market cap of $300 million to $2 billion. They often serve a niche market or new industries. There is significant risk with these funds – they have fewer resources to weather a market downturn. But smaller companies also have more opportunity for growth. Find a list of small cap funds here.

Global

These funds invest in stocks on foreign or international exchanges. They can include emerging markets which may have higher returns than US markets. There’s higher risk due to external factors in those markets. Currency collapse, forced changes in government or corruption are more common. International laws are not consistent with US and vary among countries.

Industry Specific

These funds focus on specific business sectors, like energy, communications or healthcare. Sector funds are widely available, from real estate to cloud computing. An index can be created for any industry. These funds are attractive to new investors who have an interest or expertise in certain business sectors.

Growth Based

Growth index funds include companies whose earnings are expected to outperform the market. Growth stocks can be volatile. They rise higher in stronger markets and fall further in a downturn.

Dividend Based

There are indices that compile stocks offering shareholder dividends – growth or yield. Growth indexes are based on companies that regularly raise the amount of their dividends. Yield indexes include stocks that have a high dividend yield. Dividend yield is calculated by dividing the dividend amount by the share price. Experienced investors will re-invest their dividends in a growth index fund.

Where to Invest?

Index fund investments are passive, but you shouldn’t be. Before you invest anywhere, you want to see how the fund is performing. Check sites like Market Watch (image below) or use the EDGAR database on the SEC website. Some of the information may be intimidating to new investors. Take your time and learn. There are many websites and videos with excellent information for new investors.

chart of S&P 500 index fund

Ask yourself these questions:

  • Which type of index fund interests you?
  • What are the fees/expenses associated with the fund?
  • What is the minimum investment?
  • What is the account minimum? (This is the amount of money that needs to be maintained in the account.)
  • How strong is the performance of the index itself? (That’s what the fund is trying to mimic.)
  • Is the index fund performing on par with the index?
  • What’s the risk profile? Does it line up with your own?

Understand the Costs

Once you have the answers – the next step is to decide on a broker for your fund of choice and open an account.

Cost should be a primary consideration. Index funds have lower costs than actively managed funds. But they carry administrative costs that can vary greatly. A good way to evaluate fund management is their expense ratio. The number is available in the fund prospectus. The amount will vary depending on the type of assets in the index fund. But actively managed funds will always have much higher expense ratios.

Taxes are also a consideration. You can invest in an index fund through a 401k or IRA. Those vehicles are tax-deferred – there is not tax paid until the money is withdrawn. Outside that structure, there can be capital gains taxes owed on the account.

Any investment account should be transparent as relates to costs. Brokers are required by law to provide it. Too often you may have to dig for it, but it’s required to be there. It doesn’t make sense to work with a broker who makes it harder to do business together.

Interview more than one broker. This is a relationship – you have to feel comfortable. Granted, index funds are a passive investment, so don’t expect any investment advice. Make sure you go through your shareholder reports and monitor the performance of the fund.

EFTs or Mutual Funds?

Both ETFs and mutual funds let you own shares in a broad range of companies. Both involve pooling money among investors. They are the investment vehicles for an index fund. Some index funds rely on one type of account, others do a mix of both.

Mutual funds are bought from a company. They have higher administrative costs because the funds themselves are managed. Their price is valued once a day – near the close of the market. There is almost no buying or selling within the fund. That fits well with a long-term passive investment strategy.

EFTs trade on the stock market, so the prices can fluctuate over the course of the day. EFTs have no real admin fees but can have trading costs. The benefit of an EFT for an index fund is they can respond to significant price drops in the portfolio. There may be some tax efficiencies too if your account isn’t tax deferred.

Index Fund Investing Summary

An index fund is a simple way for new investors to get into the market. No matter how much money you have to start, there are index funds with no minimum investment and low administration fees. Fidelity has a line of index funds with an expense ratio of 0%. That only means that your account won’t get it eaten up by administrative costs. There’s no guarantee that any investment will make money. We’re not suggesting otherwise.

Financial jargon, tickers, acronyms and abbreviations can seem like a foreign language. But never invest in something you don’t understand. If you’re talking with a broker and they can’t explain the fund in understandable way, step back for a minute. Study up a bit and make sure you know what you’re buying into.

If you know someone who’s investing or better yet have a friend in financial services, take advantage. For a price of a nice dinner or a few drinks, ask the questions you wouldn’t feel comfortable asking a stranger. It’s not to know everything about index funds or investing, for that matter. It’s just not okay to throw your money around until you’re on solid footing.

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