Tips on how to choose an index fund
Index funds are the fastest, easiest and most cost-effective way to add diversification to your investment portfolio. If you’ve decided to use index funds to diversify, or to create a passive “lazy portfolio,” then you’ve made a wise decision. The goal of an index fund is to model a specific stock index. The goal is not to beat the market, but to capture the market’s returns. We’ll discuss the characteristics of a mutual fund, and how to differentiate solid index funds from expensive or less-reliable funds.
What is an index fund? An index fund is a type of passively-managed mutual fund. “Passively managed” means that there’s no active manager buying and selling stocks, trying to beat the market’s return (and incurring fees). Many index funds are managed by computer software and have an extremely low, or even a zero, turnover. This makes index funds a lot more tax-efficient and more appropriate than actively managed mutual funds for taxable investment accounts. Index funds are set to track a specific stock index. Most index funds track the major American stock exchanges: the Dow Jones Industrial Average, the S&P 500, or the Nasdaq stock exchange. Other index funds track a broader index, such as the Russell 2000 (the top 2000 companies in the US, based on market cap). Still other index funds track the markets of other nations or even whole regions. Vanguard even offers an index fund that tracks the entire world’s stock market indices (VTSMX).
The key points to remember are that index funds are not actively managed by people. They don’t attempt to beat the stock market’s returns. Instead they attempt to capture the stock market’s returns (or, sadly, the market’s losses).
Index fund fees and loads
Some mutual funds have “loads” – expenses which must be paid out of the initial investment, or out of profits when you sell. No-load funds which do not charge these fees are vastly preferable. All mutual funds, including index funds, charge a management fee. This fee ranges from a super-low 0.15% to a hefty 3-4%. (Some actively-managed mutual funds charge up to 5-6% fees!) Because these management fees subtract directly from your returns, less expensive funds are preferable. Studies have shown that expenses have a huge impact on long-term performance, so pay close attention to all fees associated with your investment. Diversification within an index fund Some index funds very clearly identify what’s in their portfolio. Vanguard’s 500 index and T. Rowe Price’s Equity Index 500 fund have the same stocks in them. All Dow index funds have the same stocks in them. International funds, however, contain different numbers of stocks. Before taking comfort in how diversified an index fund is, take a look at the fund’s prospectus and portfolio of complete holdings. Choose a fund that’s well-diversified. For example, the Dimensional Fund Advisors small-cap international index fund contains some 1600 stocks. The comparable Vanguard index fund contains about 500.
Best index fund providers
In the world of index fund providers, there are really only three choices, with a fourth if you have access to institutional investors. These are listed in alphabetical order. Dimensional Fund Advisors
Dimensional Fund Advisors offer the most comprehensive index-type mutual funds. They are heavily diversified and have competitive expense rates, along with no loads. Unfortunately, DFA funds are not available to the individual investor. In order to access these funds, you must employ a money manager. In addition, there are very high minimums that must be met to invest. If you have access to these funds, they are simply the best available.
Fidelity is a leading provider of high-cost, high-expense funds that frequently underperform their benchmark indices. Fortunately for the smart investor, Fidelity now offers low-cost, no-load index funds. In fact, three Fidelity funds (the Fidelity Spartan 500 Index Fund, the Fidelity Spartan Total Index Fund and the Fidelity Spartan Extended Market Fund) are less expensive than their Vanguard equivalents.
Most Fidelity funds have a $2500 minimum. Other than index funds, Fidelity funds are simply not recommended due to their high cost and underwhelming performance.
T. Rowe Price
T. Rowe Price is an excellent company that offers outstanding customer service and has investment advisors on call over 12 hours per day. T. Rowe Price offers several index funds. However, their expense ratios are somewhat higher than Vanguard and Fidelity Spartan rates. T. Rowe Price is still an excellent choice for a beginning investor. T. Rowe Price allows an investor to start an account with $0 dollars (so long as a once-per-month automatic investment plan is initiated at the same time). For this reason alone, T. Rowe Price is a great place to start for beginners or investors with limited income.
Vanguard is the company that virtually invented passive investing with mutual funds. Vanguard has the widest selection of mutual funds covering different sectors. Typically Vanguard also has the lowest expense ratios (except for the Fidelity Spartan funds listed above). However, Vanguard funds require a minimum of $3000 to start ($2500 for most funds in retirement accounts) which, unfortunately, excludes many beginning and young investors. Vanguard is the best choice for those who can afford the minimums, but who don’t have access to Dimensional Fund Advisors funds. Using index funds to create a “Lazy Portfolio” Passive investment is the technique of choosing a portfolio of index funds, investing regularly and rebalancing periodically to maintain your target asset allocation. The goal of passive investing with index funds is to capture the overall return of the stock market (and bond market), while diminishing volatility and risk through diversification. The MarketWatch website offers a list of simple “Lazy Portfolios” that use index funds to capture market returns. These range from simple, 2-3 fund portfolios to the complex 11-fund portfolio (FundAdvice Ultimate Buy and Hold – highly recommended). Learn more about lazy portfolios .
Overall, index funds are a great way to diversify your investment and provide exposure to market returns. Index funds are not made to beat the market and may not be right for the high-risk, high-reward investor. Instead index funds are best for those who wish to get rich slowly with low volatility and more regular, predictable returns than the highly volatile low-diversification portfolios consisting mostly of individual stocks. When choosing an index fund, look out for loads and expenses, portfolios, and minimums required to open the account.