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What You Need to Know to Pick Index Funds

02/15/2019

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If you have done some investigating on different types of equity or mutual fund investment, you’ve likely come across index investing. Buying into an index mutual fund can have a number of advantages, including low management costs and rock-solid returns.
But before you buy into an index fund, there are number of things that you as an investor should know about both index funds in general, as well as ways in which some of the best index funds distinguish themselves from the pack.
This article will briefly give an of overview some of the best index funds, offering a bit of insight into several funds and explaining the respective benefits of each fund. Read on to learn more.

What is an Index Fund?

An index fund is a special type of mutual fund in which a portfolio manager designs the fund to match or track a given stock 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.

On the other hand, forms of passive investment such as index investing are focused on reducing buying and selling fees, and diversifying an investor’s equity holdings greatly by investing in an index itself.

Benefits of Index Funds

Simply put, index funds have outperformed actively-managed funds in a number of respects over the last decade or so. In addition to the lesser management fees noted above, broad-market indices have often produced better returns, particularly compared to actively-managed small and mid-cap equities.

As for large and mega-cap companies, the outlook for actively-managed funds isn’t much rosier. One report posited that index funds have outperformed similar active investment by as much as 75-85% from 2005-2015, with the S&P 500 index outperforming the vast majority of individual equities.

This information shouldn’t scare you off individual equity investment and active management, nor should it sell you entirely on index investing. But the recent trend – meaning the last 10-15 years or so – has been toward more passive investing, indexing in particular.

Risks of Index Funds

Index funds and other forms of passive investment share many of the same risks.

One issue is that index funds generally buy high and sell low, as fund managers clamor to grab a hold of a new equity as soon as it hits the top-500. This concept flies in the face of one of the most basic tenets of investment, which is buy low and sell high.

It doesn’t happen often, but funds can also change benchmarks.

The big downside of joining any kind of mutual fund is that a single investor is not in charge of the decision-making, and a fund manager must do what is considered to be most beneficial to the collective. This can include changing benchmarks and getting far away from what an investor originally bought into.

Lastly, index investors can’t harvest weak or underperforming stocks the same way an individual equity investor can. A number of low-performing stocks will likely cling to the bottom of an index portfolio as fund managers try to match a given benchmark as closely as possible.

In short, index funds aren’t a perfect form of investment. That said, the best index funds can provide relative safety, a low level of costs and maintenance, and strong returns in many situations.

The Leading Index Funds for 2018

Many of the benefits associated with index investing have been explained above. Low fees and a broad swath of stocks are often enough to incentivize investors, particularly newer investors to the equity market, to buy into an index fund.

Assuming an investor has decided that index and passive investing are the preferred investment approach, the next question becomes which index to track.

There are hundreds of index funds to select from, and it can be confusing for even experienced investors to select an index, and thus an index fund, that best suits their needs.

To help, below are a few of the leading index funds for 2018, listed in no particular order:

The Vanguard 500 Index

Using the S&P 500 as its benchmark, the Vanguard 500 (VFINX) is the first and still one the best index funds for investors that want to buy into a basket of stocks that crosses numerous industries, sectors, and market caps.

Because it’s based on the S&P 500, the Vanguard 500 is cap-weighted. This comes with a number of risks that need to be mitigated, namely the tendency for small and mid-cap stock to be propped up by top-end movement.

That said, the Vanguard 500 is very proven, and in very few cases, could be considered a bad investment.

The Russell 2000 Index

Much like the Vanguard 500, the Russell 2000 accounts for a vast majority of U.S.-based equities, and thus offers great diversity. But also like the Vanguard 500, this cap-weighted index is prone to volatility.

The Russell 2000 index represents the majority of the small-cap stocks within the market, and likely serves as the flagship small-cap index. It serves as a popular alternative to investors who prefer value stocks and up-and-comers to the goliaths in the Vanguard 500.

The Vanguard High Dividend Yield ETF

This ETF (exchange-traded fund) includes equities that pay out strong dividends, which can be a very lucrative way to decide which stocks should compose an index.

The Vanguard High Dividend Yield ETF (NYSEMKT:VYM) consists of only about 400 stocks, but all of them pay out above-average dividends. For investors who prioritize a guaranteed return on investment, investing into small, niche index such as this one provides another good option.

Picking the Leading Index Funds for the Potentially Biggest Yields

The real question for investors will be how much control they want over their portfolios. Passive investing works well for those who don’t enjoy continuously monitoring the market, while other investors won’t enjoy letting a manager and fellow fund investors dictate so much of the investment process.

But if an investor decides to go with a mutual fund, index funds have proven in recent times that they can produce strong yield with minimal costs. Moreover, the best index funds have helped expose investors to different market segments and sectors while often producing positive returns.

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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