Stock-picking can be difficult, especially if you don’t have the ability to monitor the market and your investments consistently. Managed investments — such as mutual funds and exchange-traded funds (ETFs) — have become a popular choice because they provide exposure to a wide array of securities that would otherwise be out of reach for the average investor.
So many reasons to love index funds
The fund world is vast. There are so many available options, but they are not all created equal. In fact, a majority of actively managed funds fail to beat market averages, which makes picking funds almost as difficult as picking individual stocks in my opinion.
That’s why some investors turn to index funds, which attempt to track broad as well as sector-specific indexes such as the Dow Jones industrial average, the Nasdaq, and the Standard & Poor’s 500 index. Why try to beat the market when you can match its performance?
Index funds are a good choice for investors for many reasons:
- Variety: They are widely available in all types of investment accounts, sometimes with no transaction fees involved.
- Low cost: They usually have very low expense ratios, which means that fund managers are taking a smaller cut of your total return. This is possible because managers are passively managing the portfolio, not actively managing and trying to beat the market. They’re just buying the index components with the same weighting.
- Access to ETFs: Exchange-traded index funds, or ETFs, are available to buy and sell throughout the trading day, which is appealing to some investors. Although trading commissions usually apply to ETFs, their breadth of coverage and availability make them popular with investors that want exposure to more obscure indexes.
Determine your investing priorities
Before deciding which fund to purchase, you need to understand which index is right for you. You want to decide how much risk you are willing to accept, how long you expect to invest, and your overall objective given the time horizon you have set.
Determine your tolerance for risk
You have probably heard of the major indexes like the S&P 500, which tracks a broad basket of the largest U.S. companies; but there are other indexes that track specific sectors, markets, or asset classes. For example, you could invest in a fund that tracks the S&P U.S. municipal bond index if you are looking for fixed income and safety or the S&P North American Technology Sector Index if you are bullish on tech and have some risk tolerance.
Investment objective and time horizon
It is important to understand your investment objective and time horizon. If you are young with a lot of time, then your primary objective should be growth; if you are middle-aged, you may have already achieved growth and want to shift into something with better capital preservation; if instead you are approaching retirement, you’re probably looking for income first and capital preservation second.
Once you understand your investing priorities, then you can start to learn about and think through whether a broad market index or a sector-specific index better matches your priorities.
Broad market indexes
If you believe the overall stock market, or a subset of it, is going to move up steadily, then stick to funds that track major indexes.
The Dow tracks 30 major multinational corporations. Due to its small size, it isn’t the best representation of the overall market; however, if you believe in the ability of major companies like Chevron and Wal-Mart to perform consistently, then you may want to track this index.
The S&P 500 tracks a broad swath of the largest U.S. companies, offering a diversified approach to keeping pace with the market. This index mostly represents large- and mid-cap companies with well-established businesses. With an index like this, you are only taking on market risk, as its overall performance cannot be impacted significantly by sector risk. It is suited for investors that want to simply keep pace with regular economic growth.
The Russell 2000 Index is an index of 2,000 U.S. small cap stocks. Small cap stocks are more appealing to growth investors with a long time horizon and tolerance for volatility.
There are indexes that track market sectors like real estate, health care, and utilities. Investing in funds that track these indexes is inherently more risky than investing in a broad index since they are susceptible to both market and sector risk. A sector may not consistently outperform the market as a whole and, as we have seen with real estate, they can also become asset bubbles. However, focusing on a handful of sectors can address multiple objectives and give you more control over your investments. Here are a few examples of sector-specific indexes:
The S&P 500 Health Care Index tracks those companies within the S&P 500 that are engaged in healthcare-related business, mainly insurance companies.
The MSCI U.S. REIT Index tracks real estate investment trusts, or REITs. REITs have a certain appeal because they pay dividends and are seen as long-term growth vehicles. Although they sport high yields, they also come with more risk, so adjusting the portfolio weight of these investments according to your risk tolerance is something you might want to consider.
The S&P 500 Energy Index tracks companies engaged in energy businesses like oil exploration, refining, and power distribution. If you are bullish on energy prices over the long term and like earning dividends in the meantime, then a fund tracking this index might be for you.
How to pick an index fund
This is just a small sampling of the indexes that are available on the market today. Check out the websites for companies like Russell Indexes and S&P Dow Jones Indices to get a better idea of what is available. Once you’ve found an index you like, you can search for the funds through your broker or a finance website.
Now that you know about the indexes, you need to be able to pick a good fund for your needs. Index funds are available as ETFs or mutual funds, so here are some considerations to make:
If it’s in a retirement account such as a 401(k) or IRA, it’s easiest to purchase index-based mutual funds. 401(k) accounts may only offer mutual funds, and some IRA accounts offer transaction-free mutual funds. ETFs may be available but are subject to regular trading commissions.
If you like to be a bit more active in your investing style, then ETFs are a nice choice because they are traded just like stocks: You can set limit orders and have more control over your entry points. ETFs also offer more variety because there are so many funds out there that track different indexes.
Regardless of your choice of product, make sure the fund has a low expense ratio.
Make sure the fund actually does a decent job of tracking the index. Look at the performance history of the fund versus the performance of the index it tracks, plot it on a chart and look for deviations.
Above all, make sure it matches your investment objective: If you want capital preservation and modest income, stick with bond indexes; if you want highly speculative growth, then look at small cap indexes. The purchase of index funds does not alleviate you of investment risk. Some indexes have higher volatility than others, so make sure you are investing within your comfort level.
I invest in both index mutual funds and ETFs in my retirement accounts. I don’t like to do a lot of buying and selling in these accounts because I have such a long time horizon, I’ve just been letting dividend compounding take its effect and add more each year when I make my contribution. My focus is on small cap and emerging market growth due to my age and my high tolerance for risk. But nonetheless, I am just an individual investor sharing what I have learned thus far and not an investment adviser — so please take that into consideration and educate yourself or find a qualified investment counselor to advise you.
What has your experience been with index funds? Are they an important part of your portfolio or just an anchor to balance risk? How do you select an index fund?
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