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Index funds and how to invest: A full breakdown

At a glance:

  • What are index funds?

  • How index funds work

  • Know which index the index fund follows

  • Tax and expense advantages of index funds

  • What are funds of funds? Here are the basics

  • Summary of index funds

Index funds make low-maintenance investments.

You don't need to worry about a manager changing his/her strategy: Because index funds rigorously track specific indexes, the manager doesn't have much say in the matter.

Don't fear that your manager will leave for greener pastures, either: Index-fund managers aren't actively selecting stocks, so it doesn't matter much who is calling the shots.

Finally, asset growth isn't an issue, because indexing is a relatively low-turnover approach, index funds don't suffer under the weight of too many assets.

Choosing an index fund isn't such a snap, though. More than 250 index funds ply their trade in 27 different investment categories.

To complicate matters, some investment categories (such as large-blend) have multiple index funds, many of them locked to a different benchmark. It's getting so you can't tell the players without a program.

To simplify the process of choosing an index fund that meets your needs, consider the following suggestions.

A trader works during the opening bell at the New York Stock Exchange (NYSE) on October 2, 2019 at Wall Street in New York City. - US stocks continued to fall at the markets' open on Wednesday, as disappointing employment data added to the gloom from a dismal manufacturing report on Tuesday.Tuesday's losses wiped out gains won in the third quarter by the benchmark Dow and S&P 500, and the downward slide continued. (Photo by Johannes EISELE / AFP) (Photo by JOHANNES EISELE/AFP via Getty Images)
A trader works during the opening bell at the New York Stock Exchange (NYSE) on October 2, 2019 at Wall Street in New York City. (Photo: JOHANNES EISELE/AFP via Getty Images)

What are index funds?

Many investors wanting their investment portfolios to keep pace with the market choose index funds.

Why choose index funds?

An index fund is a mutual fund constructed to follow or emulate the performance of one of the market indexes.

Simply stated, index funds contain the securities that make up major market indexes. They do not try to beat the market. Instead, they try to match their reference market index. An index fund that tries to match an index would hold the same securities that are in that index. The fund may weight the number of shares for each company it owns in proportion to the share price or company capitalization.

For example, it may buy more shares of a company whose share price is lower than one with a higher share price.

Alternatively, it may buy more shares of a large company than of a small company regardless of share price. The fund's prospectus describes the method of allocation. The fund may try to mimic the formula used in the index itself to achieve the same results as the index.

Low management

Index funds often use little to no active management. In many cases, computer-trading software dictates the portfolio allocation to match the chosen index. Buying and selling are infrequent when compared to funds with broader investment objectives because market indexes do not add or replace securities very often. As a result, portfolio turnover and management expenses are low.

Some commonly used indexes include the S&P 500, the Russell 2000, and Bloomberg Barclays U.S. Aggregate Bond Index.

The SP 500 index is a basket of 500 stocks that are considered to be widely held. The SP 500 index is weighted by market value (shares outstanding times share price), and its performance is thought to be representative of the stock market as a whole. This index provides a broad snapshot of the overall US equity market.

Over 70% of all US equity value is tracked by the SP 500. Inclusion in the index is determined by Standard and Poor's and is based upon its market size, liquidity, and sector. SP 500/Citigroup Growth Index comprises stocks in the SP 500 with high price/book ratios relative to the SP as a whole. SP 500/Citigroup Value Index comprises stocks in the SP 500 with low price/book ratios relative to the SP as a whole.

The Russell 2000 index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 index is a subset of the Russell 3000 index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

The Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, US dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS, and CMBS.

The US Aggregate rolls up into other Barclays Capital flagship indices such as the multi-currency Global Aggregate Index and the US Universal Index, which include high-yield and emerging markets debt. The US Aggregate Index was created in 1986.

How index funds work

Investment markets are very complex. To build a portfolio of securities that consistently outperforms all other portfolios can be difficult. Since index funds own the stocks that make up the index, the fund is designed to perform as well as the market measured by the index.

Using an index fund gives these investors a chance to at least match the market. However, if their index underperforms another index, their index fund can do likewise.

Index funds have pros and cons

The advantage of index funds is that they are designed to keep pace with the market. Their downside is that they generally do not outperform the market.

Some fund managers buy the top-performing stocks in the index instead of all the stocks in the index in an attempt to "beat the market." Such funds, however, are not considered true index funds.

Same index, different weights

Even index funds that use the same index can be structured differently. Some allocate their holdings evenly among the index stocks. Others allocate a greater proportion to bigger companies than smaller ones. That is why different funds that use the same index may have different returns.

Their competitive returns and lower management fees have made index funds popular for years. There are still management fees to consider, however, and they will vary across funds, so it would be wise to take the expenses into consideration. Lastly, like all investments, index funds have risk.

If the benchmark the fund is tracking against is experiencing losses, it is likely that investors will have losses as well.

Know which index the index fund follows

Vanguard, Domini, and Schwab all have funds in the large-cap blend category.

They all claim to be index funds. But their performance patterns have been very different over the years.

What gives? The funds may be large-blend, but they track different indexes.

Knowing what index a fund tracks gives you a handle on the risks and returns you can expect and how they differ from other index funds.

Know your options

Thanks to the variety of index funds, you have much more flexibility than decades past, when tracking the S&P 500 was one of the only indexing options.

Today, you can build a well-balanced portfolio made up entirely of index funds.

Here are some common indexes; there are various funds tracking these indexes, or some variation on them.

U.S. stock indexes

  • Wilshire Large Growth: Screens 750 largest U.S. stocks for sales growth and other growth indicators.

  • S&P 500: 500 of the largest U.S. stocks, both value and growth.

  • Wilshire Large Value: Screens 750 largest U.S. stocks for lowest P/E and P/B ratios, and highest yields.

  • Wilshire Mid-Cap Growth: Screens 501st to 1,250th largest U.S. stocks, following same criteria as Wilshire Large Growth.

  • S&P 400: 501st to 900th largest U.S. stocks, both value and growth.

  • Wilshire Mid-Cap Value: Screens 501st to 1,250th largest U.S. stocks, following same criteria as Wilshire Large Value.

  • Wilshire Small Growth: Screens 751st to 2,500th largest U.S. stocks, following same criteria as Wilshire Large Growth.

  • Russell 2000: 1,001st to 3,000th largest U.S. stocks, both value and growth.

International indexes

  • MSCI World: Captures 85% of every developed country's market capitalization and industry sectors, including the United States.

  • MSCI EAFE: Captures 85% of market cap and industry for 21 countries in Europe, Australia, and the Far East, excluding the United States.

  • MSCI Emerging Markets: Applies MSCI criteria to countries identified as emerging by in-house guidelines.

Bond indexes

  • Barclays Capital Long-Term Govt/Corp: Treasury, agency, and corporate bonds with face values more than $100 million and maturities of at least 10 years.

  • Barclays Capital Interm-Term Govt/Corp: Same criteria as Lehman Brothers Long-Term, but maturities of at least one year and less than 10 years.

Tax and expense advantages of index funds

The holdings in an index fund are not traded often because they are held to match an index. Most index funds are passively managed. Managers of actively managed funds trade their securities more often. This results in capital gains and capital losses.

When a fund has net capital gains, its shareholders must pay taxes on the capital gain distributions, even if they are reinvested. Most index funds have little capital gain distributions subject to tax. Some investors think of this characteristic as a tax advantage.

Why the fees are lower

Since most index funds are managed passively, management expenses are lower compared to actively managed mutual funds. Two funds composed of the same securities will perform the same. However, the one with lower expenses has an advantage.

The tax effects of index funds

One of the most common myths about indexing is that all index funds are tax-efficient.

Funds that buy the biggest stocks can boast terrific tax efficiency.

That's because stocks that drop out of the large-cap S&P 500 usually are pretty small players in the index (most companies drop out of the index precisely because they've become too small)—after the 225th stock, none accounts for more than 0.10% of the index.

When index funds sell these smaller positions, they don't reap sizable taxable gains.

Don't expect tax efficiency from funds tracking other indexes, though.

For example, funds following smaller-cap indexes have to sell stocks that have grown too large to remain in the small-company index.

Because those are also the funds' largest positions, selling them means realizing large capital gains, which then have to be distributed to shareholders.

Where to find more information

Some research firms such as Morningstar can help you see how tax efficient an index fund is.

The costs of index funds

A common assumption about indexing is that all index funds are cheap. Because they don't demand the resources of active management, they certainly ought to be.

But some index funds charge surprisingly high annual expenses. Consider this: one S&P 500 index fund takes a huge 1.40% bite out of your investment every year.

That is awfully steep when you consider that the average large-blend index fund's expense ratio is 0.60%. And even that looks pretty stiff compared with some that charge even smaller fees.

Of course, you might willingly pay more for some index funds because you want the screens they apply in deciding which companies to include in their indexes. But all things being equal, cheaper is better.

What are funds of funds? Here are the basics

Funds of funds are mutual funds that invest in other mutual funds. That may sound redundant, but it's true.

How they work

Just as a regular mutual fund offers the skills of a professional manager who assembles a portfolio of stocks or other securities, the manager of a fund of funds will select a portfolio of funds, managed by other managers.

It's an advantage if you want only one fund to invest in

If you have only a small amount to invest each month, a fund of funds allows you access to more funds than you might be able to afford on your own. It also allows investors to avoid the recordkeeping and paperwork that comes with owning an assortment of funds.

Here's the downside

So what's the catch? Expenses, mostly.

The fund of funds structure creates a double layer of costs. First, there are the expenses associated with running the fund of funds itself—management fees, administrative costs, etc.

Second, there are the costs associated with the underlying funds—the same sorts of management fees, administrative costs, and so on.

A fund of funds may report an expense ratio of just 1%, but keep in mind that you're still paying the expense ratios on each and every fund that the fund of funds owns.

How some companies get around the downside

Some fine funds of funds eliminate the double-fee problem. Families such as T. Rowe Price and Vanguard offer funds of funds that invest only in their own funds. The families then waive the cost of the funds of funds—their reported expense ratios are 0%—and you only pay the costs of the underlying funds.

Obviously, these funds are a cheaper option.

Summary of index funds

Some say you cannot beat the market. So why not join it? Many try to beat "the market" only to be disappointed that their portfolios didn't do as well as the S&P 500 or the Dow Jones Industrial Average.

Index mutual funds provide a way to invest in a portfolio that closely mimics a particular index so it will perform at least as well as the market it tracks. These portfolios have the added advantage of lower costs due to their passive management.

If you are looking for an investment that keeps pace with a particular investment market, then index mutual funds may be worth looking into.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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