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Everything You Need to Know About Index Funds Before You Invest

02/15/2019

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If you have considered investing in equities or bonds, it’s likely that you’ve heard about index funds. What readers may not know is exactly what an index fund is, or how to go about investing in or purchasing one
Before an investor can appreciate – and thus utilize – the broad exposure to the stock market that index funds can offer, it will help potential investors to understand what index funds are, and what they aren’t. 
This article will break down everything that an investor needs to know about index funds prior to purchasing a fund, offering some of the pros and cons of this form of investment as well as few suggestions for index funds to perhaps focus on.

What is an Index Fund?

Index funds are constructed to match or track most of the individual components of a market index. The most commonly-copied index is the Standard & Poor’s Index 500 (S&P 500), which most investors believe best represents the current U.S. equities market.

An index mutual fund provides a number of benefits, including exposure to a broad number of markets and sectors, relatively-low operational costs, and low portfolio turnover. Indices such as the S&P 500 are considered to be broad-market indices because they tend to reflect the movement of the entire market.

Many indices are cap-weighted indexes, meaning that market capitalization is the primary driver of the index. That said, investors can buy into indices organized in a number of different ways such as by dividend yield and market sector.

Index fund investment is a type of passive investing, which holds a number of advantages over equity trading and other forms of active investment.

The main way in which a passive investment strategy is superior to active investing is that passive investments such as index funds offer lower MERs (management expense ratios). This ultimately can mean more money in your pocket.

Mutual funds such as index funds are also subject to a number of rules and standards that do not change regardless of the state of a given market. This offers investors additional protection and mitigates some of the risk associated with investing in individual equities.

More on Passive Investing and Index Funds

Passive investing is an approach in which investors maximize their eventual returns by keeping buying and selling to a relative minimum. The most-popular forms of passive investment today include index mutual funds and bond mutual funds.

One of the reasons that this type of investment has become so popular is that investors are still seeing strong returns while minimizing management fees. Because index investing is designed to mirror a given market, managers are not constantly buying and selling equities, and investors realize significant savings in this regard.

For those who do not love scouring market reports for the latest changes, passive investing can certainly be an effective way to supplement or even increase income.

Why Invest in an Index Fund?

As explained above, index funds and other forms of passive investment have become quite popular in recent years, as many investors have turned away from the fees and hassle that come with active equity trading.

Index and mutual fund fees tend to be minimal, with account fees and expense ratios averaging about 0.1%-0.2% of the total value of the purchase every year. Weighed against active trading, which can incur fees of $7-$10 per trade or more, index funds can serve as a very cost-effective alternative for many investors.

In addition, index funds probably require the lowest amount of account maintenance. While investors will want to keep an eye on most of the equities within a given fund, index funds come with more of a “set it and forget it” mentality.

It’s usually in the investor’s best interest to not get too caught up in the day-to-day fluctuations of a given index. Indexing, and passive investing in general, works better for people who are comfortable placing an amount of money into an account and riding out some peaks and valleys.

In short, there are a number of good reasons to consider index funds, with the main reasons being the light fee schedule and exposure to most of the market.

Having acknowledged that index funds come with a number of benefits, there are also a number of drawbacks associated with index funds. The risks listed below will need to be mitigated by an investor or fund manager.

Myths and Misconceptions about Index Funds

While index funds can be great investments and a great way to generate passive or supplemental income, they do come with a handful of risks that need to be mitigated by investors.

A big misconception about index funds is that an investor is completely protected by purchasing an index fund because the investor has purchased a huge basket of stocks. This isn’t quite the case.

The theory is that by investing in diverse market sectors such as consumer goods, healthcare, and real estate, an investor seemingly covers all of his or her bases with index investing. This is true, and is one of the biggest benefits of buying an index fund.

But while indexing does provide broad market exposure, the market as a whole can still decline.

Healthcare, for example, could be on the rise, but most of the other markets could experience declines or recessions.

That said, those who believe in the market itself think that index investing will ultimately lead to great returns. Investing into a broad-market index fund is, in many respects, investing into the U.S. economy itself.

Risks Associated with Index Funds

As explained above, index funds come with a number of risks that investors will want to mitigate in the interest of increasing  yield.

It’s initially important for an investor to know exactly what the fund invests in. Index funds can include baskets of stocks numbering the dozens or hundreds, and it’s in the investor’s interest to communicate with the fund manager and know exactly which equities are in a fund at any given time.

Next, while index funds are likely to be less volatile than most individual stocks, they are only as stable as the underlying benchmark or index. Indices can rise and fall much like an individual equity, though the broad-market aspect does reduce the volatility.

In general, the more exotic the index, the more the investor needs to put it under the microscope. While a plainer, more-established index such as the S&P 500 is more trustworthy, an exotic or leveraged index ETF such as the Vanguard FTSE Emergent Market index could come with amplified loss/return factor.

This loss/return factor could be triple that of an index such as the S&P 500, reducing some of the risk management that comes with index investing.

An investor will also want to check the index fund’s holdings to keep their money in all of the right places. It would be smart to ask the fund manager if the ETF holds actual stocks. Also, clarify whether it’s a synthetic fund, which is an underlying index – with derivatives – where it’s tracked without having to own any share. It’s a good idea for an investor to have a working understanding of the differences between physical and synthetic ETFs, so that the investor or manager can mitigate the specific risks.

Where to Purchase Index Funds

There are a number of avenues for purchasing index funds, each with their own respective advantages, disadvantages, and fee schedules.

Most first-time investors would probably do best to purchase an index fund through a mutual fund company. While investors can save themselves a fractional amount doing their own investing via an online brokerage service such as E-Trade or Ameritrade, the counsel and guidance that come with a good mutual fund manager is likely worth any additional costs incurred.

Investors can buy an index fund from a large company such as Vanguard, which operates the prestigious Vanguard 500 Investors Share Index. This highly-popular index tracks the S&P 500, which most finance experts consider to be the most-accurate barometer of the American economy.

However, there are a number of advantages to going with a local, smaller mutual fund firm or group. The main advantage is that an investor can develop a relationship with a local manager, and consequently, a manager working for a smaller company may be more apt to perform better if he or she has a smaller client list.

Lastly, investors have the option of purchasing from multiple managers or brokerage firms, which is probably the best way to ward against overlap. This should take place a few months or years down the road, after an investor has become acclimated to the market and to index investing.

The Verdict on Index Funds – Is This the Best Way to Invest?

Index funds are certainly a popular, and in most situations, an effective place to put some investment capital. If an investor is reasonably patient, he or she can see exceptional returns from index investing, especially if the investor opts to try investing in an index with high-yield dividends.

That said, active investing is on the rise, and in many cases, there is a greater potential return on an actively-managed individual equity investment. But index funds can also produce good returns, particularly if a novice investor is not fully acclimated to the market.

Linden Thomas & Company

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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