Quite possibly the toughest part about investing in stocks for most people is choosing from the thousands and thousands of listed companies in the marketplace. Stock selection can take a lot of your time and energy. This can especially happen with so many companies rising to potential in this market. When you are getting into investing in stocks, it is only par for the course that you will need to do your homework. And of course, research on these companies. But sometimes, it can be too much to handle. There is also the possibility of missing out on a particularly profitable stock. Because you have accidentally overlooked it in your research.
That is why index funds are such a major staple in the investment world. In recent years, index funds account for quite a portion of the total amount invested in stocks. It makes sense since investing in an index fund introduces investors to a more diversified portfolio of stocks. It is increasing their chances of gaining average returns. And, perhaps even above average returns if they are lucky.
What is an Index Fund and How Do They Work?
An index fund is a mutual fund with a portfolio. It is a grouping of financial assets that tries to correspond to the performance of a major market index. And index fund supposedly provides market exposure, low portfolio turnover, and, more importantly, low operating expenses. Simply put, it allows the regular investor to participate astutely in the stock market by offering diversification at low costs.
It is non-existent
It should be kept in mind that an “index” does not really exist in a way. An index is just a hypothetical idea, a mere academic concept, that is a list of rules set up by a committee on how to construct a stock portfolio of individual holdings.
Investing in index funds or “indexing” is what is known as a passive form of fund management that has been proven successful and has even outperformed most actively managed mutual funds. What this means is that fund managers of an index fund are just seeking to replicate or match (rather than beat) the performers of a given index. Because of this passivity, they will not need the services of research analysts and the like in the stock selection process, essentially lowering management expenses.
The Dow Jones Industrial Average
Still, you might be wondering how it all works. Let us take one of the oldest and most famous index funds of all time, the Dow Jones Industrial Average. It is a list of blue-chip stocks and is said to be made up of a representative collection of stocks that are crucial to the United States of America’s economy. Shares from the DJIA are weighted based on the stock’s price, and adjustments are made for stock splits (an accounting transaction designed to make the nominal quoted market value of shares more affordable).
The Dow Jones Industrial Average achieves matching the market index by investing in the same companies as the average and at the same proportions. In this manner, if the average goes down, the same will happen to the fun. If the index improves, the fund does too. Stocks in the DJIA are selected by editors of the Wall Street Journal. Because changes in the market are rare, the DJIA has been highly passive. However, it has beaten other indices – like the widely discussed Standard and Poor’s 500 (S&P 500) – over long periods of time by quite a margin.
The S&P 500
The Standard and Poor’s 500, the most widely followed index, on the other hand, has a more complex methodology. The S&P 500 consists of five hundred hand-picked big companies by the Standard and Poor’s. It weighs stocks according to their market capitalization. S&P 500 is a good choice if you are looking for market efficiency since you can benefit from whatever logic the market made to allocate decisions.
Basically, with buying an index fund, instead of having a portfolio manager making selections for you, you are outsourcing the capital allocation job to the individuals or group deciding the index methodology. If you invest in an index fund in DJIA, you are essentially delegating the job of managing your money to The Wall Street Journal. And if you get an S&P 500 index fund, you are entrusting the folks over at Standard and Poor’s to manage your money. Simple as that.
Advantages of Index Funds
We touched upon this earlier, but index funds are ultimately much more beneficial than actively managed funds. Investors who do not have large capitals are better off investing in index funds. Here are just a few advantages of index funds:
Index funds are generally less costly than actively managed funds. Of course, not all index funds are low costs, but a good portion of them are. The reason why they are more affordable is that they do not need to fund analysts, traders, managers, and a whole lot of experts to give you a perceived value. With an index fund, you are just going with the average so you will not have to spend that much money. You will save quite a lot in fees.
Guaranteed Average Returns
Unfortunately, aiming for above-average returns lead mostly to failure. Average returns are difficult enough to achieve. However, by investing in index funds, you are guaranteed at least average returns because the index fund is the average. So when you invest in an index fund, you have already achieved the average.
Index funds are quite popular for investors looking to fatten up their retirement plans. One of the greatest investors of all time, Warren Buffet, advises investors to buy low-cost index funds consistently. By investing this way, you can achieve the market average and in a few decades have quite a bit set up for retirement.
Outperform Actively Managed Funds
Lastly, if you feel like making the average return is enough, know that with an actively managed fund, you stand and 80% chance of ending up with less money than you started with. Simply put, your chances are improved when you invest in index funds.
Index Fund Weaknesses
While investors can enjoy a variety of benefits from index funds, they still have a few drawbacks that you need to know about before investing.
Index funds can be overvalued. Depending on the company or the price of the stock, you could end up holding on to an overvalued index fund.
They are specifically designed not to aim for huge gains or growth. Index funds only match a certain index so you will not see the type of gains you normally see if you are a day trader.
Index funds do not represent all sectors and industries, so your choices are a bit limited.
In volatile times like a Recession, index funds can be quite volatile. Granted, most investments are at risk when the economy gets into a spot of trouble.
Common Misconceptions about Index Funds
Even though index funds are largely quite transparent and basic, people still do not quite understand them. The Internet does provide investors with a blitzkrieg of information that may be invaluable to people, but it can also be overwhelming once you go down the rabbit hole. Sorting out truth from myth can be tricky with so many resources available online. And with such a broad and complicated topic as investing, it is only expected that investors would get a little confused. There have been a few misconceptions about what an index fund can and can’t do so let us get the facts straight.
Not All Index Funds are Inexpensive
While it is true that index funds are considerably cheaper than most actively managed funds, that does not mean that all index funds are inexpensive. There are expensive index funds too as well as inexpensive active funds. There are even cases where the cheapest actively managed fund is less costly than an index fund. However, on an asset-weighted basis, index funds are generally cheaper than its active counterpart. Like with most aspects of investing, it’s best to do thorough research before investing, especially if money is tight.
Index Funds are Tax-Efficient
Because of their low turnover rates, broad market equity index funds are usually quite tax-efficient. However, it is worth noting that not every index fund will always be like that. In recent years, sizable redemptions have disturbed some index funds. This has triggered some security sale and large capital gains. Big index funds weighted by capitalization, on the other hand, have experienced massive inflows.
Also, if traditional index fund tracks result in frequent trading and turnover, it could also signify meaningful capital distributions.
Index Funds vs. Exchange-Traded Funds (ETF)
Although it can be said that there is not much variation between index funds and exchange-traded funds (at least on a fundamental level), the two still do have some differences when it comes to tax efficiency, trading, reinvesting dividends, and other factors. While it all depends on the individual investor to decide which to choose, it does help to know which is more advantageous than the other. When it comes to trading costs and the ability to reinvest dividends and capital gains, it is the index fund that has the upper hand. Meanwhile, if you are looking for a bit more tax efficiency, the ability to trade more than just once intraday, as well as strategic beta opportunities, the ETF has the advantage.
7 Most Profitable Index Funds in the U.S. for 2018
If you are convinced that investing in index funds is the right move for you, you might want to consider these index funds that analysts and veteran investors advise. There is a lot of index funds to choose from and, hopefully, our list will help you narrow down your searches.
Schwab S & P 500 Index Fund (SWPPX)
Issued by the Charles Schwab Cooperation more than ten years ago, the Schwab S & P 500 Index Fund is a mutual fund that aims to provide investment results corresponding to the total return of the S&P 500 index. This index fund is advised and managed by Charles Schwab Management Inc. SWPPX has an expense ratio of only 0.03%.
The way SWPPX goes about achieving its investment goals is by investing at least 80% of its total net assets in stocks from the S&P 500 index. Generally, SWPPX gives the same weights to the stock as the S&P 500 index.
Schwab S&P 500 Index fund has total net assets of around $29.2 billion with 508 holdings as of October of last year.
Vanguard Emerging Markets Stock Index (VEMAX)
If you asked investors ten years ago whether it was worth investing in emerging markets, they would probably tell you no. However, just recently, these markets have blossomed, and despite still posing a few risks, they have also proven to be one of the fastest growing portions of the global economy. Its annual expense is 0.14% too which is 90% lower than the average expense ratio of funds from similar holdings.
With this index fund, investors are offered an inexpensive way to gain equity exposure to emerging markets from around the world. VEMAX currently has a fund total net assets of $82.9 billion. It is also managed by Vanguard, one of the most successful curators of mutual funds right now.
The Vanguard Emerging Markets Stock Index has assets in almost every part of the world, focusing on developing countries for the most part. VEMAX has holdings in South Africa and Latin America, as well as Eastern Europe. Its assets in Asia are also impressive. VEMAX has 71% of assets in all of Asia, 32% of that is in China alone.
While emerging markets in some areas in the world can be more volatile and risky than others – this is especially true for stocks from developing countries – Vanguard Emerging Markets Stock Index still offers an index fund that can imply the potential for greater long-term returns. This is definitely for investors who want to diversify their international portfolio. Of course, you will need to be an investor that focuses on the long-term results as well as someone who does not mind taking a few risks for higher rewards.
Vanguard Total Stock Market Index (VTSAX)
Another index fund managed by Vanguard. Majority of Vanguard Total Stock Market Index’s assets are in stocks in large companies. However, it also owns assets in small to midsize stocks. VTSAX offers investors the entire U.S. equity market for the meager expense ratio of 0.04% every year.
This mutual fund’s key attributes are its wide diversification, low costs, and high potential for tax efficiency. Currently, VTSAX’s fund total net assets are $701.2 billion.
You might want to consider the Vanguard Total Stock Market Index if you are looking for an inexpensive way to gain broad exposure to the US stock market but you are also willing to accept the volatility that comes with stock market investing.
Fidelity Spartan 500 Index Investor Shares (FUSEX)
This index fund aims to offer exposure to a basket of common stocks that are included in the S&P 500 Index. The Fidelity Spartan 500 Index Investor Shares can serve as a core holding in a portfolio of US equities.
FUSEX was issued way back in the late 1880s by Fidelity and has since grown to be one of the top funds of its kind. FUSEX has an annual expense ratio of 0.09% and has a perfect correlation to the S&P 500 index.
The way FUSEX works is that, to track the underlying index under normal market conditions, it invests at least 80% of its total net assets in common stocks comprising the index. The Fidelity Spartan 500 Index Investor Shares has a history of tracking the index with only a small degree of tracking error.
FUSEX is low-cost exposure to the US large-cap equities market and is a good choice for investing if that is what you are looking for.
Vanguard Developed Markets Index Fund Admiral Shares (VTGMX)
If you are an investor looking to invest in markets outside the U.S., the Vanguard Developed Markets Index Fund Admiral Shares is a good pick. At a low cost (expense ratio annually is only at 0.07%), investors are provided a diversified exposure to small-, mid-, and large-capitalization companies in developed markets from around the world. You will have access to markets in Europe, Japan, Australia, and more.
Foreign stocks have made quite the comeback in recent years, so it is good to take advantage of the market right now. However, since the VTGMX focuses on foreign stocks, it can be a little more volatile than domestic stocks. It also suffers from the same risks as most funds concentrating on foreign stocks like the currency risk or the exchange rate risk. Moreover, because the fund most likely invests in a large portion of its assets and securities of companies located in any one country, VTFMX’s performance may be hurt disproportionately by the poor investments in that one area.
That being said, the Vanguard Developed Markets Index Fund Admiral Shares is a fund that has higher risks but poses higher rewards so if you are more of a long-term investor, this might be a fund worth giving a second thought.
Vanguard High Dividend Yield Index Investor Shares (VHDYX)
Investors wanting additional income ought to consider the Vanguard High Dividend Yield Index Investor Shares. This fund will not only offer additional income but also provide some downside protection. Dividend stocks tend to outperform their non-dividend stocks in harder times, and that is always a plus for any investor.
The VHDYX has an annual expense ratio of 0.15%, which may not be as low as the other products Vanguard has to offer, but it could be worth it in the long run.
The main goal for this income-focused fund is to track a benchmark that provides broad exposure to domestic companies that are known to pay higher than average dividends to their stockholders consistently. By focusing on slower growing but high yielding companies, the VHDYX could have a total return that may not be as strong in a significant bull market. It also suffers from general stock market risks.
But if you are the type of investor who prefers to dabble in the stock market and has long-term goals, this fund should be right up your alley.
Vanguard Short-Term Corporate Bond Index (VSCSX)
Lastly, it is always good to get a bond fund to give you that stability you will need in times of trouble and the Vanguard Short-Term Corporate Bond Index is a good fund to start.
With an annual expense ratio of 0.07%, this low-cost index fund invests in domestic dollar-denominated, fixed-rate, investment-grade, taxable bonds issued by industrial, financial, and utility companies.
However, because this is still a bond fund, the VSCSX suffers from the risks most bond funds face. For one thing, there is a chance that increases in interest rates will cause the prices of the bonds in the portfolio to decrease. However, it is worth noting that this risk is not as big of a threat like in funds with longer average durations.
Ultimately, this fund is ideal for investors with short-term savings goals who can stomach the risks that come with price movement.
There is a lot to be said about index funds. People have varying opinions of investing in them, but it all boils down to the individual investor’s preference. If you have a fairly modest portfolio and you are still not quite sure what you are doing, an index fund could be advantageous for you. They are safe enough to hedge your bets on and will save you a world of trouble.
Index funds can be these incredible tools that can help you up your investment game as well as lay a good foundation underneath you. You can save a lot of money with an investment fund, which can be good for beginners who are still hesitant to throw in a considerable sum to investments. Ultimately though, index funds are not good nor are they bad. They are tools that you can utilize, and you should always keep that in mind. As an investor, it is best always to be pragmatic when it comes to making investment decisions.