Index funds in a nutshell

An index fund is a kind of security that you can invest in; its main feature is that it tracks a financial index such as the S&P 500. In other words, it mirrors the return of the market as a whole. It can be structured either as an index mutual fund or index ETF, but this doesn’t matter all that much: both serve the same purpose of providing broad market exposure at a low cost and with no trading fees.

Index funds are a form of passive investing that track benchmark indices. The manager of the index fund will buy shares according to the weighting of the index. For example, if Apple (AAPL) shares make up 5% of the Dow Jones Industrial Average, then the fund manager will keep 5% of the fund in Apple. This means investors can count on getting the same performance of the index without buying and selling all the individual stocks themselves.

Are index funds a good investment?

Billionaire investor Warren Buffett famously said that he would advise most non-professional investors to invest in an index fund. He also instructed the trustees in charge of his estate to invest 90% of the holdings in S&P 500 index funds and the other 10% in US Treasury bills.

If the fact that an investor of that stature recommends index funds as a safe investment is not enough, let’s explore the specific benefits of investing in index funds…

Diversification (Wider market exposure)

In investing, diversification – owning a number of differentiated assets – is standard practice to reduce the risk associated with individual investments in your overall portfolio. For example, let’s say you invest in two stocks. If one of them goes to zero, you have lost half your investment and the other stock would have to double in value to just so you can break even. On the other hand, if you have 500 stocks in your portfolio, the effect of each stock on the performance of your portfolio is much less drastic.

Lower fees (Reduced operating expenses)

When investing in a fund, the key cost is the expense ratio. This figure tells you how much you will pay in fees every year as a percentage of your investment. The expense ratio covers everything from paying the fund manager to operating costs to transaction fees, accounting, and taxes.

Low-cost index funds will typically have an expense ratio of well under 0.5%, which makes for a big saving versus the 1% to 2% fees typically charged by active managers, who often also charge a performance fee on top.

Long-term success (Predictable profits)

These funds track the performance of well-known indices, composed of established, stable companies that are virtually sure to, on average and over time, increase in value. As long as the investing axiom that stock markets will always rise in the long run still holds, it is a great argument in favour of investing in the broad stock market itself with index funds.

Drawbacks of investing in an index 

The increasing growth in the number of funds as well as the increasing percentage of money invested in index funds is testament to their popularity and that their pros seem to well outweigh the cons. However, it would be foolish to put money into any investment without understanding its shortcomings (and perhaps investigating a few other options).

Volatility

One of the purported advantages of investing in an actively managed fund that is is that the fund manager can take measures to reduce volatility by hedging. A passive investment tracking an index, on the other hand, accepts all its ups and downs. Every few years, there is a bear market during which an index can fall by over 20%. Investors need to be prepared to weather these bad times and keep their eyes on the long-term return.

Cannot beat the market

By its nature, an index fund tracks the underlying index and is never expected to beat it. Given the strong performance of the overall market in recent years, coupled with the proliferation of new hedge funds, most active managers do not beat the index anyway, though.

Vague risk of a passive investing bubble

There are some who see the inflows into passive investments like ETFs as a bubble and believe that this may end up skewing the market. This is not in any way proven, and so should probably not be seen as a reason not to invest in index funds, especially given their strong track record of stability and performance.

Index funds: Mutual funds vs ETFs

Both ETFs and mutual funds have their proponents and detractors. In many ways, though, the difference in outcome of investing in either a mutual fund or ETF is negligible. Both do a good job of tracking the index and charge low fees. 

Oftentimes, the main reason for selecting one or the other will be what is most easily available on your investing platform. Online platforms based on stock trading tend to focus on ETFs, while the pension fund you might invest in through your employer will often only offer mutual funds.

How to start investing in mutual funds

There is no need to hire a financial advisor to pick an index fund, though you can if you prefer. Index funds are not specialist investment products, so they do not require any analytical skills or investing knowledge to invest.

We have identified the following steps to take if you want to start investing in index funds.

One – Decide on goals for using index funds

In this crucial step, the main consideration is your investment time horizon. Will you retire in five or fifty years? The general recommendation is to take fewer risks the closer you are to retirement. If you are about to give up your regular income, your goal is capital preservation. By contrast, if you have just begun investing and have decades ahead of you, capital appreciation is your main goal. Index funds carry higher risk than bond funds or money market instruments, which may be more suitable for older investors.

Two – Pick an index

There are two main considerations when picking the best index fund: returns and volatility. As they always say: “past performance is no sure predictor of future returns”, but it’s often the only information we have. Risk and return normally go hand in hand, so stock indices with higher performance tend to have larger drawdowns and vice versa.

You can find the annual performance of any index over certain time periods online, as well as each’s “maximum drawdown”, which is the largest amount it lost from peak to trough in any given period. 

Three – Research the best available index funds

Most index funds do a good job of tracking their chosen index, so the main consideration is fees. There are, however, some other factors you’ll want to check out, not least the nature of the indices various funds mirror. One of the most trusted resources for researching index funds is Morningstar.

Four – Open an investment account 

While you can approach some mutual funds directly or with the aid of a financial advisor, It’s usually easiest to register on one of the many online investment websites and apps. These allow you to trade a variety of equities, including most of the major index funds and index ETFs.

Five – Buy the index fund

This can easily be done once you’ve deposited some cash in your chosen mobile app or desktop trading platform. At the same time, you can also look into other investments you may care to make, from individual shares to forex trading.

Six – Set up a reinvestment plan

While leaving a lump sum invested in an index fund allows you to take advantage of compound interest, the best way to build wealth is to consistently invest 10% to 20% of each paycheck. In many cases, your bank can automate this monthly transaction for you.

Low-cost index fund examples

Though we do not recommend any of these funds in particular, we thought it would be helpful to include a list of some of the most prominent index ETFs and mutual funds in various markets. You can use these as a starting point for your own research.