Why invest in index funds?
The beauty of index funds is that you’ll get a neat package of bundled stocks. Therefore, as an investor, you don’t have to pay a money manager to choose your investments for you. This means that index funds typically give way to high returns and lower fees in the process.
Pros and cons of index funds
The pros and cons of index funds should be carefully considered before you run out and buy one.
- They’re liquid. Liquidity in this case simply means that you can buy or sell at the end of the trading day at the fund’s net asset value. Though they’re not as liquid as stocks, which can be bought or sold at any time during the trading day, mutual funds are still some of the most liquid investment options available. ETFs can be the best of both worlds, in that they offer diversification and can be purchased on margin like stocks and you can short sell them, too. They also trade at a price that is updated throughout the day, just like stocks. You’ll get real-time pricing every time you buy and sell.
- Passive vs. actively managed. Less of your investment goes toward fees and expenses when you invest in index funds.
- They’re tax-efficient. Index funds pay fewer dividends than actively managed mutual funds and they also have a low turnover rate. (Low turnover refers to the amount of funds that have been replaced, or turned over, during a given year, which results in capital gains taxes.) Low turnover equals low taxes, so index funds are a great place to park your money if you’re interested in lowering your tax bite.
- Index funds don’t represent all sectors and industries. Indexes can favor only certain sectors.
- You won’t be able to see huge gains or growth. Since index funds follow an index, they’re not going to see the type of gains you could see as a day trader.
- They can be turbulent in times of volatility. Index funds were volatile during the Recession; a money manager may have been able to lessen the impact.
- They can be overvalued. If, based on a company’s price-earnings ratio, expected earnings or condition, or if the stock price is deemed too high, it’s overvalued. If it’s in your index fund, you could have a bunch overvalued stocks. If you’re a savvy investor, you’ll take that into serious consideration before putting all your eggs in one basket.
How to choose index funds
Before you leap, look into a few things:
- Do your research on the broker you’re considering. Read Benzinga’s articles to gather as much information as you can about various brokers. Also, read everything you can online. Do customers talk about the broker you’re considering in forums? Have they had problems with the broker’s platforms? Frustrations with customer service? Take that to heart, and maybe even a grain of salt. Oftentimes, these online brokers serve millions of customers. If there are fifty complaints and that’s it, well, in the grand scheme of things, that’s not so bad.
- Check on commissions and fees. Just check on them so you can be amazed at the low fees you’ll find. The Vanguard 500 Fund, for example, has an expense ratio of just 0.12%. Low cost, indeed.
- Are there some promotions going on with certain brokerage firms? A cash bonus? Something more? Obviously, that should not be the be-all, end-all for your decision, but if you qualify, that could be a very good thing.
- Choose an index. The most popular index funds track the S&P 500, but there are several other indexes that are also used for index fund tracking (the Barclays Capital Aggregate Bond Index is one example of one).
Why index funds over single stocks?
In sharp contrast to trading one single stock, an index fund can showcase a broad range of securities, offering more diversification compared to one stock. In addition, the risk is greater for single stocks over index funds.
Commissions and fees
If you choose to go the route of active management instead of indexing, you pay for the possibility of outperformance. According to Morningstar, the average actively managed fund fees are approximately 0.78% in annual fees, whereas the average index fund annual fee is about 0.18%.
Best index funds
Benzinga has compiled a list of a few of the best index funds, and they include the following:
1 year return: 14.71%
5 year return: 13.14%
Expense ratio: 0.14%
1 year return: 14.71%
5 year return: 13.16%
Expense ratio: 0.09%
1 year return: 14.52%
5 year return: 13.45%
Expense ratio: 0.04%
1 year return: 16.54%
5 year return: 12.39%
Expense ratio: 0.06%
1 year return: 9.46%
5 year return: 11.40%
Expense ratio: 0.08%
If there’s one takeaway, just remember that passively managed index funds can beat managed funds over time. If you’re interested in finding something you’d like to hold for the long term and won’t eat up your money through expenses, seriously consider index funds for your portfolio.