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Investing in Index Funds: Everything You Need to Know about the Rules


This article will overview much of what an investor should know about index funds, examining some of the rules and underlying processes that go into compiling a given index and explaining how to invest in index funds. Read on to learn more.

Which Criteria Determine Stock Selection for an Index?

Before you know how to invest in index funds, first understand that indexes can be constructed in a number of different ways, with the most basic way to list the total number of stocks collected on a given index.

Examples of this would include total market indexes such as the S&P500 or the Russell 3000. Both of these indexes are capitalization-weighted indexes, meaning that equities with higher market caps are more apt to be included.

Unless an index or fund is sector-based, market cap will mostly likely be a primary determining factor.

While the S&P500 is a bit more exclusive, the Russell 3000 attempts to provide an almost-complete representation of the U.S. stock market, listing over 98% of publicly-traded stocks.

Meanwhile, the Dow Jones Industrial Average (DJIA) is a highly-exclusive price-weighted index that limits membership to 30 active stocks with high prices-per-share. In the eye of many investors, the Dow provides the purest reflection of the U.S. economy.

The Dow, to the dismay of some, does not heavily factor market cap. When economists make statements such as “the market is up,” they are ordinarily referring to the Dow, as the stocks included on the Dow are generally indicative of the U.S. economy on the whole.

In short, criteria that are typically considered when constructing an index can include a company’s number of shares outstanding, the total number of shareholders, and as mentioned above, market capitalization.

Approaches for How to Invest in Index Funds

Ideally, an investor wants to buy into an index fund within a sector that he or she understand so that the investor can eventually self-manage the fund.

Because index funds are passively-managed, the investor does not typically require a broker to select stocks, and consequently individual investors can often manage and monitor their chosen fund after the initial setup. Compared to individual equities, index funds can be relatively low-maintenance.

Carefully Choose a Broker

The first part of the process for most investors will be to do some broker-shopping, and to determine which brokerage has the most palatable fees.

Oftentimes investors will be able to handle the entire index fund investment process online, but in other situations an investor will prefer to develop an in-person relationship with a broker or fund manager. Either approach is fine, and both have their respective merits.

While considering different brokering options, it would be to the benefit of most investors to check on commission-free options, as well as to determine the trading costs for index funds in advance. Generally, stocks can be bought and sold for about $10, but this fee can double for index funds.

Find an Index Fund That Best Serves Your Goals

Next, the investor will choose which index most closely aligns with her or his financial objectives. Many investors like the S&P500 because they believe it provides the best overview of the U.S. market, but it’s not the only index fund available to investors.

Investors who understand in a particular sector such as Health Care particularly well might opt to invest in a sector-based index such as the Health Care Select Sector (IXV). While it’s typically prudent to diversify investments, in some cases sector-specific investment might present a better market opportunity.

Investing in a sector-based index would be an alternative to investing in a total market index, but circumstances will largely dictate if this is the right call for a given investor.

Novices would probably be better served investing in a bigger basket, and thus a total market index, until they have a better feel for the market on the whole.


Lastly, costs have to be considered. While index funds are generally less expensive to buy into due to their passive nature, fund management will still incur administrative fees.

In the information-gathering stage, investors will want to check and see what an index fund’s minimum investment will be, in addition to a mutual fund’s expense ratio – the sum administrative and marketing costs that an investor will incur for account management.

Tax-cost ratio is another factor that will cut into the annual returns from an index fund investment. Comparing the different tax costs and potential liability between index funds, combined with the management expenses, will give you a better idea of which fund makes the most sense for you financially.

How to Invest in Index Funds to Increase Returns

Index funds can be an effective way for notice or first-time investors to buy into a broader market selection, somewhat offsetting the risks inherent to equity investment.

Though index funds do not require the same rigorous monitoring as individual equities, an investor will still need to do homework before committing to a particular fund to ensure that the expected fees, risks, and taxes are palatable compared to the potential 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).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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