How to invest in index funds

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This is the third installment of a three-part series examining index funds. In Part I, we looked at the managed mutual fund market. In Part II, we looked at how an index is calculated and what an index fund is. In this installment, we'll consider how to evaluate index funds and where to buy them.

Despite the fact managed mutual funds still dominate the mutual fund landscape, there has been a steady migration of assets from managed funds to index funds and ETFs (most of which are indexed). In fact, there are more than 350 index funds from which to choose, so when you start to look into investing your money in an index fund, you'll need to understand these two things:

  1. What kinds of index funds are available
  2. Where do you get them

Types of Index Funds

Some people classify money market funds as index funds because they're passively managed, but money market funds are not based on an index. Instead, three broad categories describe how index funds are generally broken down, as shown in this pie chart from ICI data:

The chart shows:

  • The major distinction in index funds is between stock funds (the common name for equity funds) and bond funds.
  • You can also see that approximately 80 percent of all index fund money is invested in stock funds, either domestic or international.

How to Decide on an Index Fund

Into which type of fund should you place your investment? To help you decide, here are a few important things to consider.

Stock Funds

  • Stock funds mirror the stock market. Over the long haul (more than a hundred years), stock values have consistently risen. In addition, they also offer cash dividends — the S&P 500 currently yields close to 2 percent per year in cash dividends.
  • The stock market moves in cyclical waves and hits a major downturn every ten years or less. In some years (like the last two or three), it does exceptionally well; but down cycles wipe out most of those gains. Nevertheless, depending on which year you choose as a base, the long-term return in the stock market has averaged 7 to 9 percent per year.
  • More than 40 percent of all domestic stock fund assets are invested in funds tracking the S&P 500 alone. In other words, by far the most popular index funds are those that track the S&P 500. There are, quite literally, hundreds of other stock index funds from which to choose. Reviewing each one falls beyond the scope of this post; but if you want to learn more about which ones to invest in, simply Google “stock index funds” and begin looking.
  • When it comes to stock index funds, the most important factor to look at is the cost (the annual management expense and sales load if there is any). All index funds which track the same index should give you the same return, so cost is the major deciding factor. It's generally accepted that Vanguard (Mr. Bogle's company) is the low-cost leader in index funds.

If you want to get started with something simple, you won't go wrong by picking the largest index fund of all, the Vanguard 500 Index Fund, the one that started it all (Symbol: VFIAX). There has also been a large fund covering the entire stock market — not just the 500 biggest companies — as well as other index funds which slice and dice the stock market to any flavor you might want.

Bond Funds

Most people understand what stocks and the stock market are because those make headlines daily. The bond market, on the other hand, is less known, even though the bond market is roughly twice the size of the stock market worldwide. Part of the reason for its obscurity is it's not nearly as easy for individuals to buy bonds as it is to buy stocks, and, compared to stocks, they're … shall we say … boring. Many people don't even know what a bond is.

What is a Bond?

A bond a piece of paper documenting a debt. Earlier this year, for example, Microsoft sold bonds. Each bond cost $1,000 and pays interest quarterly, in cash, calculated at 2.724 percent per year, until 2025, at which time they will pay back the $1,000 to whoever owns the piece of paper (or bond).

There are thousands of bonds, each with a different maturity date and interest rate, and these trade daily on exchanges worldwide. You can see their prices on the same newspaper pages showing stock prices. Deciphering those quotes might be a little trickier, but bonds are as numerous and as frequently traded.

A few characteristics distinguish bonds:

  1. No growth: Companies will retain profits to invest in growth which increases the value of their stock over time. It's not the same with bonds: A bond is issued at $1,000 and will be redeemed (repaid) at $1,000.
  2. Interest income: A bond is a debt instrument, and its purpose is to generate a cash interest income every year. Many stocks (like Berkshire) never pay dividends, and rely on retained profits to grow in value.
  3. Valuation cycles: Bonds, as we said, are traded daily. Even though a bond is issued at $1,000 and will be redeemed at $1,000, the value at which it trades rarely will be $1,000. That's because changes in prevailing interest rates change the market value of bonds. The mechanics fall outside of this discussion of index funds; but suffice it to say that, when interest rates go down, the market value of bonds goes up (and, of course, the opposite is true too).Therefore, while stock prices move according to cycles closely tied to the economy, bond values don't. Bond values depend almost entirely on interest rate changes. If you want an investment that will not be severely affected by a stock market crash, a bond fund becomes a good candidate.
  4. Classes: Stocks are stocks, for the most part. Some pay dividends, some don't, but there isn't a vast difference in classes of stocks. Bonds, though, are different, and are broken down into three groups with two general risk classes:
High Grade High Yield
Government Government
Muni (state/local government) Muni (state/local government)
Corporate Corporate

Bewildering Bonds

Individual bonds may be hard to buy as an individual, but bond funds are just as easy to buy and hold as stock funds are.

Again, a good starting point is the largest bond fund out there, Vanguard's Total Bond Market Index fund (Symbol: VBMFX), which recently replaced the big PIMCO bond fund. Vanguard's fund invests about 30 percent in corporate bonds and 70 percent in U.S. government bonds of all maturities. Because the fund invests in all segments and maturities of the fixed income market, it is a good way to get your toe in the bond fund water, so to speak.

(Please note: That we mention Vanguard's two index funds is not an endorsement. We are merely pointing out the largest stock and bond funds as a starting point for your consideration.)

Most smart investors strike a balance between stock and bond index funds. No two people have the same ratio, nor is there an ideal balance.

Index funds usually outperform managed funds and have lower expenses. That makes them the ideal investment vehicle for folks who don't want to spend their days analyzing potential investments.

Where Do You Buy an Index Fund?

Figuring out which index fund to buy is the hard part. But once you have decided what to invest in, you can move on to tackle the easy part. In general, there are two ways to buy index funds:

  1. Unrestricted: You can choose whichever funds you want to buy. This may be as part of a tax-advantaged plan (like a Roth IRA) or just a general account with a broker or a financial services firm like Fidelity, Vanguard, etc.
  2. Restricted: You are limited as to what funds you may invest in, e.g., your employer's 401(k) or similar tax-advantaged retirement plan.

Unrestricted — You need an account with a brokerage, or with a mutual fund company like Vanguard. Going with a single company limits you to funds from that institution. And while a brokerage account allows you a wider selection, you will pay commissions for that freedom.

You can purchase index funds for either a tax-advantaged account (like an IRA) or for a regular investment account. Buying an index fund is similar to buying a stock: You simply specify the ticker symbol and the quantity, and you buy.

Restricted — This is a little trickier, because most employers' retirement plans have a limited menu of funds from which you can buy, usually dominated by plans from the plan administrator (T. Rowe Price, Fidelity, Vanguard, etc.). Most plans allow you to make frequent changes, but be aware that they will sneak a plethora of fees and charges up on you for those changes. So your best bet is to do your research early and then stick with what you buy.

When you get your employer's fund menu, look for the index funds.

Hint: Those typically are the ones with the lowest fees. If they don't offer index funds, ask them to provide them.

Reviewing the Options

The best way to minimize your investing risk is by diversifying, and the most common way to achieve diversification is through mutual funds, which come in two flavors: managed and index. Index funds typically offer the lowest costs and the highest performance, which makes them the no-brainer choice to get rich slowly.

Your primary challenge is to figure out your ratio of stock funds to bond funds, and then which specific funds to buy. There are no recipes for the ideal balance, nor is one index sure to outperform all the others. Given that most funds tracking a specific index will (by definition) have the same return, the most important variable you need to look out for are the expenses charged by the fund.

Have you been investing in index funds? Or have you been waiting to learn more about them before taking the plunge?

More about...Investing, Retirement

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