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Everything You Need to Know About How to Buy Index Funds

02/12/2019

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Learning how to buy index funds can be one of the most important steps people make in their wealth creation journey. These are low-cost vehicles designed to give small-scale investors access to capitalistic economic growth.

A Crash Course on Index Funds

Index funds are passive investment vehicles that allow investors to gain exposure to a broad range of securities without paying the expenses associated with asset management. Index mutual fund shareholders gain indirect ownership of the securities held by the fund itself, which pools the assets of a large number of investors. Mutual funds and ETFs are creative solutions for investors with relatively small amounts of capital, for whom proper diversification and rebalancing can be difficult or impossible. Indexed mutual funds arose as reams of research assailed the perceived value created by portfolio managers who actively pick certain securities.

Indexing is a passive strategy that bases fund allocation on the relative weighting of benchmark index constituents. The S&P 500 Index, various S&P 500 sectors, the Russell 2000, the Dow Jones Industrial Index and the Nasdaq 100 are all popular US equity indexes that are tracked by numerous mutual funds and ETFs. The largest stocks in these groups are typically the ones with the highest exposure in the tracking funds.

Index mutual funds have become very popular in recent decades, because they allow investors to gain exposure to economic growth via broad-based business ownership without incurring high management expenses that erode holdings without creating additional value on a consistent basis.

A Brief Guide to Identifying the Right Funds

There is no universal solution or best option for investors evaluating index funds, but there are some general considerations that should be helpful for someone evaluating opportunities in their personal plan.

First, investors should verify that their portfolio allocation is aligned with their personal risk tolerance, investment horizon, liquidity needs, important ethical stances, and any regulatory limitations on security ownership. These considerations can be addressed through a risk tolerance questionnaire, the creation of a comprehensive financial plan, and consultation with a financial professional.

The results of the above exercises should indicate the ideal portfolio exposure to equities and fixed-income securities, with even more detail illustrating the desired balance of different characteristics within those asset classes.

Equity investors should pay attention to market capitalization, geography, sector, industry, and valuation, while yields, maturity, and credit risk are important considerations for bond investors.
Indexed mutual funds can be useful tools to gain exposure within the guidelines dictating security characteristic exposure. There are popular funds designed to track various benchmarks such as large U.S. companies, large international companies, small U.S. companies, specific industries and sectors. and companies from developing nations.

Evaluating Index Funds like a Professional

Even within the benchmark-specific categories outlined above, investors often have numerous choices among index funds offered by different financial institutions.
Mutual funds are often judged on trailing performance, management tenure, and management compensation. But these factors are less reliable when evaluating a fund mandated to track an index rather than deliver maximum returns.

Instead, investors should judge index fund quality on expense minimization and ability to mimic the returns displayed by the target benchmark. The expense ratio is an important metric to determine fund operational efficiency, and lower expense ratios are better for net returns, all other factors being equal.
Also, pay attention to less apparent costs such as trading volume, marketing costs, and transaction fees charged by the fund. Minimizing the turnover ratio can improve net returns, as can seeking shares with the lowest loads, 12b-1, and transaction fees.

Use resources like Morningstar to analyze the correlation between an index fund and its target benchmark. If care is taken at the macro level to determine optimal portfolio allocation, the constituent pieces of that portfolio should match stated strategy as closely as possible, otherwise they would not be working in unison toward a cohesive goal.
Finally, share class is an important consideration for indexers. Single funds may offer multiple share classes, commonly grouped as A, B, or C class shares, and the distinction among classes generally reflects the timing and level of transaction fees. The suitability of each depends on factors such as time horizon and purchase size.

Where and How to Purchase Index Funds

Index fund shares can be purchased directly through a broker or through the services of an advisor. Online brokerages have proliferated in recent decades through technological advances and stiffening competition. These channels will generally offer the lowest potential cost for investors.

As previously noted, anyone purchasing through a brokerage should research the fees associated with the platform and ensure they meet the minimum investment requirement. Once the brokerage has been selected and the appropriate paperwork has been filed, purchasing an index fund is relatively straightforward.Many investors find value in the educational, non-emotional, and consultative aspects of an advisor relationship, making that an attractive option for some people. Moreover, some mutual funds are only marketed through wholesale channels, meaning access to these funds is limited for the do-it-yourself investor.

Advisors have relationships with brokers, and will generally walk through the considerations outlined in this article to develop and implement a personalized strategy. Some advisors handle portfolio creation, trading, and rebalancing themselves, whereas some will outsource the actual management of client funds to an institutional investment management platform. They are generally compensated either by commissions on trades or through a management fee based on assets under management.

Risks, Drawbacks, and Important Considerations

Indexing is a low-cost strategy that has improved consumer welfare in the investment world, but no strategy is perfect. Market-level volatility is still a threat to asset value, and simple indexing offers no protection to the downside experienced following the Dot-com bubble or the 2008 Financial Crisis.

Actively managed funds tend to outperform their indexed counterparts during market contractions. Opportunity cost is real, and irrational behavior serially plagues retail investors, even those embracing low-cost passive strategies.

Mutual funds are popular indexing vehicles, but investors need to consider their merits relative to ETFs, especially with regards to liquidity and tax-related expenses.

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