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How to Invest in Index Funds: Everything You Need to Know

02/15/2019

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Many potential investors have read up on the benefits of index investing, but maybe don’t know how to to go about joining a pre-existing fund or what the specific risks and rewards might be.
If you have been looking for information on how to invest in an index fund, this article will provide an overview for the process and help point first-time investors in the right direction.
This article will better explain how to invest in index funds, offering some suggestions for which funds to target and clarifying the advantages – and corresponding risks – of index fund investment versus individual equity investment.

What is an Index Fund?

An index fund is a certain type of mutual fund in which a portfolio manager designs the fund to match or track a given stock index. Examples of popular index funds include the Vanguard 500 Investor Shares and the Schwab S&P 500 Index.

The logic is that by investing in the index itself rather than a particular basket of stocks, an investor is exposed to a broad number of equities ranging a wide variety of industries, sectors, and market caps.

This somewhat offsets some of the risks posed by individual equity investment, which can include overinvestment in a failing equity, being stuck with a sinking stock, and excessive trading fees.

All of these are risks that need to be mitigated during active investing.

Due to these risks, many investors have taken to passive investing as a way of reducing fees and maintaining diversity within their portfolios.

What is Passive Investing?

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 are likely index mutual funds and mutual bond funds.

One of the reasons 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 maximize income.

Why Invest in an Index Fund?

In short, the results are there, especially if an investor or potential investors give greater weight to the last 10-15 years. Index funds have simply outperformed most equities over this timeframe, once trading fees are factored.

While active or individual equity investment has historically produced stronger returns, indexing and mutual fund investment has never been more popular.

Options for Buying an Index Mutual Fund

There are several options for buying into an index fund. A few of the more common approaches will be briefly discussed below.

Purchasing a Fund from a Mutual Fund Company

An obvious option is to purchase mutual funds directly through financial institutions offering them. This process can usually be completed online, and does not often require a trip to a firm or brick-and-mortar location.

That said, many people – rightly and smartly – want to meet with an investment advisor in-person and develop a relationship with a fund manager.

Many mutual fund companies have numerous brick-and-mortar locations nationally, and local options could likely be found with a routine internet or phone book search.

Several well-established investment firms in the United States and abroad offer a wide range of index mutual funds. In many cases, these institutions can offer a plan that will suit almost any investment need.

Most firms offer at least a few index funds in different categories that can range from domestic to international to fixed income. These different funds have been designed to be attractive to different investors, allowing them to create diversified portfolios.

This method would be for the investor who may be cost-conscious, and have a willingness to invest on his or her own without much professional advice or consultation.

Going this route is probably the least costly, with management fees averaging about 0.1 to 0.2% of the investment in the fund. But it does require some due diligence and a bit of finance and investment acumen.

Buying from a Number of Companies

Some investors prefer not to buy multiple index mutual funds from just one company, in the interest of diversifying account management and minimizing the potential for overlap.

Companies such as Vanguard, Fidelity, and T. Rowe Price all offer in-house brokerage accounts and strategic investment. One of the functions of these accounts is that they all offer the ability to buy and sell index mutual funds offered by other firms.

Investors should know that purchasing additional mutual funds from rival firms will likely incur transaction fees for the buyer, not unlike banks or other instructions that have loose working relationships. These fees will vary a bit from firm-to-firm.

Potential investors can usually begin this process online, though investors may want to meet with representatives from the various companies to get a feel for the culture of each. Smaller local companies might be able to dedicate more time and attention to a client than a bigger national company.

Online Brokerage Firms

Another possible option is to set up an online brokerage account through a trusted brokerage site such as AmeritradeE-Trade, Merrill Lynch, or Charles Schwab.

Typically, online brokerage firms charge a transaction fee for each trade, and may also charge additional account setup or maintenance fees.

To give investors a rough idea of what these fees could entail, E-Trade and Ameritrade both have stock trade fees of $6.95, but E-Trade charges $19.99 for a mutual fund trade while Ameritrade charges $49.99.

Potential investors can check out the complete fee schedules of online brokerage firms, and decide for themselves if this approach is how they wish to invest in index funds.

This option could also work for the investor who feels comfortable investing by themselves. While these respective online brokerage do provide some education and investment guidance on their websites, investors will need to a decent amount of self-educating if this is their first go-around with equity or mutual fund investment.

Hire a Financial Advisor or Finance Expert

The final option would be to locate a financial advisor, planner, or broker, and have this individual assist with account setup and management.

A good financial advisor can assist in the selection of index mutual funds, help handcraft a portfolio to meet your particular financial goals, and monitor the process while the investor learns.

This option would also require an investor to open a brokerage account(s), and would incur the associated fees. Before going with a financial advisor, it would be in the interest of any investor to do some rough math and account for the charges and fees that going this route would possibly incur.

Additional Index Fund Fees to Consider

While many of the fees associated with purchasing an index fund are presented above, different firms and brokers will have unique fee schedules.

It’s the responsibility of the investor to inquire about any potential fees prior to investing, in order to improve yield and make an informed purchasing decision.

So, if you want to know how to invest in index funds while keeping fees to a relative minimum, you should also consider asking about the following fees prior to closing on a particular fund:

Commission or Sales Charge

This is a fee that an investor will pay upfront. A firm or broker might have a per-share commission or sales charge of 3-5% per share. It’s of course important to determine this figure prior to purchase.

Expense Ratio

Investors will encounter expense ratios at any firm or brokerage they use to manage their index fund.

An expense ratio will be expressed as a number from 10 to around 150, and refers to the ongoing percentage taken from the fund for account management and servicing. An expense ratio of 120 would mean that the company or firm will collect 1.2% of the total asset worth in the fund every year.

Expense ratios aren’t usually negotiable, but an investor can shop around a bit prior to investing to find a broker or firm with a palatable annual rate.

Redemption Fees

Alternately known as a “surrender charge,” these are the fees that an investor incurs for selling shares early. These fees are again around 3-5%. If a share sells for $20.00 per share with a 5% redemption charge, an investor would redeem a total amount of $19.00 per share.

Additional Service Fees

Every brokerage or firm is going to have its own fee structure, and it’s important to check on any additional account servicing or management fees you could incur at any point in owning an index fund.

How to Invest in Index Funds for Additional Passive Income

The main appeal of index investment for most is that it’s a mostly hands-off approach. While it behooves any investor to monitor their investment, indexing does not require the vigilant account maintenance and constant turnover associated with active trading.

Whether you are looking to generate a bit of additional passive income or prepare for eventual retirement, knowing how to invest in index funds is another way in which a person can put away a bit of investment capital and anticipate a solid, or even spectacular, return.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

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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