[Throughout the course of today’s article on index funds, there will be links to prior topics that I believe are beneficial to understand. If you are unfamiliar with them, please take the time to read these previous posts so that you can take full advantage of today’s shared knowledge. Additionally, please take a moment to review my disclosure policy if you haven’t yet here.]
There has never been a better time to invest than now, well, other than yesterday. Why? Had you started yesterday, you could have already begun growing your nest egg. So, the next best time to invest is today!
Tune out the fear-mongering static that preaches an imminent market crash because you will never invest if you are waiting for it. Had it been obvious, everyone else would be waiting, too. Timing the market is the equivalent of trying to catch lightning in a bottle. It cannot be done; well, not consistently, at least.
I knew a guy who once bottled lightning, but his skills were fried after that!
One of the easiest and most powerful ways to save for retirement is through the use of funds, which invest in a wide variety of securities for you. As you will recall from my previous article, What is a Fund? A Guide to Mutual Funds & ETFs, funds are companies that buy and sell investments for you, eliminating the need for individual stock or bond picking. Instead, you choose a fund that matches your objective, and it does the rest for you!
Now funds come in two primary flavors, Active and Index. If you are unfamiliar with the differences between Active and Index funds, now is a great time to review my prior post, Active or Index: The Real Answer.
As a synopsis, active funds try to beat the market while index funds try to mimic it. With active funds, there is no guarantee that they will do this; with index funds, you are guaranteed the performance of the market.
The market refers to all investments of a particular type and their behavior due to buyers and sellers utilizing them.
Now, as the title of today’s post suggests, I want to demystify index fund selection for you. Whatever your reasoning is for investing in index funds, this article is for you! While strictly educational and not advice, this post will give you the knowledge needed to evaluate funds critically.
Too often, blogs, forums, and other financial mediums preach the wonders of index fund investing while never explaining how to choose the right one. So join me as I define what an index fund is, the different types, and cover considerations relating to expenses, turnover ratios, and fund managers.
How do index funds work?
An index fund is a regulated company that buys, holds, and sells various investments while following a particular benchmark, which it attempts to mimic in composition and performance.
English translation: Index funds buy and sell investments for you in hopes of mimicking a benchmark.
Now, for those unfamiliar with indexes, ever heard of the S&P 500 or Dow Jones? These are indexes! The S&P 500 is the Standard & Poor’s benchmark that tracks the largest 500 publicly traded companies in the United States.
Indexes are tools that investors use to track their performance relative to everyone else and that commentators use to describe what the market is doing. In this case, the market is the index being referenced. Some indexes specialize in technology companies, while others mimic entire economies or geographic regions. If you can name a segment of the global economy, there is probably an index for it.
Now indexes generally follow either one of two asset categories: Stocks or bonds. While others exist, I will only be covering these two today. If you are unfamiliar with either, now is an excellent time to learn the basics by reading Not Your Grandma’s Guide to Stocks & Bonds. However, for those familiar with these two asset classes, our discussion moves forward!
How to choose an index
The first and arguably most critical step in choosing an index fund is deciding which index to follow. Because index funds are companies that invest on your behalf by mimicking a benchmark, selecting the wrong index could lead to dismal performance or unnecessary risk.
For example: If you want to follow the entire US stock market, choosing a fund that focuses only on US manufacturing companies would be too narrow of a benchmark. On the other hand, investing in a total US market fund would be wasteful if you want to invest in companies tied to global solar panel production. Thus, be mindful of the index you choose!
If you have heard the phrase bigger is better, now is the time to internalize it. With indexes, generally, the bigger the index, the better. Why? People invest in indexes to lower their risk and participate in market gains rather than picking and choosing individual investments. By buying every company that makes cars, you are more likely to buy a winner.
Thus, the larger the number of underlying assets, the more diversified you are, mitigating your risk. Diversification is an investor’s best friend. While you won’t overly benefit from one company that outperforms, you also won’t miss out on its gains entirely.
On the flip side, if awful news strikes a particular company, such as the death of their CEO or a scandal unfolds, you are not over-exposed to it. Benefits to indexes include exposure to market sections and reaping benefits of trends that all companies partake in, such as increased demand for cars.
Now for those who want manageable hands-off portfolios while still being in control, they should consider total market indexes, which are the cream of the crop.
Total market indexes capture the performance of entire markets. For most do-it-yourself US investors, owning a total US stock market index, total international stock market index, and a total bond market index should be considered. These three components are the building blocks of a diversified portfolio. If you want to add in other investments to play with, go for it. But using these three components as a backbone will help give you the best shot at success while minimizing risk.
Should I buy an indexed mutual fund or ETF?
Now that you have decided what type of index or indexes you will invest in, you have to determine if you want to own the indexes as an ETF or a Mutual fund. Here is a brief refresher on the differences between these two types of investment companies.
Mutual funds can be transacted in any dollar amount, and all transactions occur at 4 pm EST, Monday through Friday. On the other hand, ETFs can be bought and sold anytime during regular stock market hours. Still, they must be purchased and sold in pre-determined increments. Generally, ETFs tend to be more tax-efficient when held in after-tax brokerage accounts than mutual funds. In contrast, mutual funds are easier to purchase.
For those who want to automate their investing, mutual funds are the easiest choice. Most large brokerages allow you to create automated schedules to buy specific dollar amounts repeatedly with mutual funds. So, for those trying to dollar-cost-average, mutual funds are the easiest choice. ETFs can be a better choice for those wanting to get in and out of the market with ease or looking for the most tax-efficient vehicles.
You cannot go wrong with either at the end of the day; pick whichever format makes you most comfortable!
Additional Considerations: Cost, Turnover, and Management
Now that you know which index and type of fund you will purchase, you must weigh the fund’s cost, turnover rate, and management. These three factors are critical when choosing a fund as they can weigh your performance down or lead to additional tax consequences.
As with everything in life, funds have costs associated with them, and investors should control these to the best of their ability. Unlike active funds, which can sometimes offset their fees through outperformance, index funds only perform worse when their expenses are higher.
Think about it: The greater the costs associated with mimicking something, the lower the likelihood is of having the same results! Now costs come in three flavors: Loads, transaction fees, and expense ratios. Do not pay loads or transaction fees; these are outdated charges from a prior era of the investment industry. Nowadays, most investors can invest at any big-name brokerage house and never pay these fees, so you shouldn’t either!
As for expense ratios, these are all but unavoidable. As I covered in The Hidden Cost When Investing: Expense Ratios, expense ratios are the day-to-day costs to run your fund. Funds are businesses, after all, and as a result, they have costs they must manage while investing on your behalf.
Thus, choose a low-cost expense ratio fund and do not pay load or transaction fees.
In my prior post, Turndown for what! I covered how turnover ratios can drag down fund performance, especially for indexes. Turnover ratios refer to the frequency with which a fund buys and sells its investments. For example, an 8% turnover ratio means the fund trades 8% of its portfolio during a year. The higher this ratio is, the more costs a fund will incur. As a result of increased costs, the fund will likely experience underperformance. When choosing an index fund, make sure that it has a single-digit or low teen turnover ratio; by doing this, you will help ensure more consistent and reliable performance.
The last consideration for choosing an index fund is settling on a fund manager. A fund manager refers to the company that operates your fund. Examples of fund managers include Blackrock, State Street, and Vanguard.
This category is much more subjective than the factually established prior categories. Still, there are ways to tie your decision back to the facts. To do this, weigh if there are cost savings by going with a particular fund manager. Some managers offer accounts, in addition to funds, and usually will not charge load or transaction fees on their funds. Examples of fund firms include Charles Schwab, Fidelity, and Vanguard.
Now, many investors preach the benefits of certain firms due to their ownership structure. With Vanguard, you buy ownership in the company when you buy their funds. Charles Schwab is a publicly traded company that anyone can purchase through stock shares in a brokerage account. Fidelity, on the other hand, is privately held. If you think there is an advantage to any of these models, weigh it during your decision-making process. For those looking for additional guidance, see my prior post: How To Choose A Firm.
Congratulations, you made it! Now you know the significant considerations to weigh when choosing an index fund. First, you must select an index and decide how to buy it through either a mutual fund or ETF. Once you have done this, you can weigh the costs, the turnover ratio, and firm-specific preferences you have to settle on the right choice.
Below is a list of some of the more popular index funds for US investors. While not recommendations to buy or sell, these are a reference for educational purposes. Thanks for reading and chime in using the comments below to tell me which index funds you think are the best or if you evaluate funds differently. As always, have a great day!
Charles Schwab US Aggregate Bond Index Fund – SWAGX
Fidelity Total International Index Fund – FTIHX
iShares Core S&P 500 ETF – IVV
State Street MSCI Global Stock Market ETF – SPGM
Vanguard Total US Stock Market Index – VTSAX
Mile High Finance Guy
finance demystified, one mountain at a time
Hey Olaf, great article. Out of curiosity what makes ETFs more tax-efficient in after-tax brokerage accounts? Have you written anything on it before? Would be interested in understanding more!
Hey, the Real Estate Captain! I have not covered that yet and will devote a future post to it, but it boils down to their business structure.
With Mutual Funds, all transactions take place between you and the fund. This means that if more people want to buy or sell your fund, you have to go out and buy or sell more of the managed portfolio.
With ETFs, once created, they are bought and sold by regular investors. The fund packages them up and sells them off, and then trading happens between people like you and mean.
Thus, when there are increased redemptions of mutual fund shares, the fund manager will have to sell some of the fund’s assets. Because these sales are likely to include appreciated assets, there will be gains. These gains must be distributed to the mutual fund shareholders so that Uncle Sam can get his tax cut; this is mandated by law.
With ETFs, the underlying investments do not have to be sold, and as a result, they have fewer capital gains.
If you hold mutual funds and ETFs in a tax-advantaged account, like an IRA or 401(k), this doesn’t matter. However, if you keep them in a brokerage account, pay attention.
That’s interesting. I need to dig in more on my after-tax brokerage accounts as I’ve always just used mutual funds. Thank you and look forward to a future post!
Definitely worth taking a look! If you already have appreciated gains on your mutual funds, the tax-savings are generally greater to continue to hold them rather than to sell and move to ETFs. However, it gives you the basis to invest strategically going forward!
Just threw the post up here, thanks for the inspiration! https://milehighfinanceguy.com/etfs-tax-efficient/