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The commission wars are over and the retail investor is one of the few parties who can claim a total win. While brokers can make plenty of money in other ways from various services (or selling order flow), those who invest with a buy-and-hold mentality will reap benefits in the long term as money that used to go to commissions and fees will now compound like the rest of their capital.
For most investors with long time horizons, index funds are the way to go. An index fund might not be a glamorous or exciting investment, but if you aren’t digging deep into the guts of the market and economy every night, you likely won’t become an elite stock picker. Especially not over a multidecade period. Index funds are both low-cost and liquid, making them ideal for all kinds of portfolios.
If you’re looking to start investing in index funds, you’ll need to pick a suitable broker. A strong list of commission-free ETFs is no longer enough to spike the punchbowl – everyone has commission-free ETFs now. When choosing a broker, you’ll need to think about your financial goals while comparing the features and offerings.
- Best Online Brokers for Index Funds
- What is an Index Fund?
- Pros and Cons of Index Funds
- How Does an Index Fund Work?
- Types of Index Funds
- Index Funds Should be a Staple for any Investor with a Long Time Horizon
- Frequently Asked Questions
Best Online Brokers for Index Funds
Index funds are core holdings in both taxable and tax-advantaged accounts. When choosing a broker, you’ll need to look at more than just index fund availability since everyone’s got cheap ones now. You’ll want a broker that meets your needs as an investor. Here are our top choices.
Lowest Fees Overall: Interactive Brokers
Interactive Brokers Lite clients enjoy commissions as low as Interactive Brokers Lite clients enjoy commissions as low as Interactive Brokers Lite clients enjoy commissions as low as $0 for US-listed stocks and ETFs and the lowest commissions on stocks, options, futures, currencies, bonds and funds from a single integrated account for US-listed stocks and ETFs and the lowest commissions on stocks, options, futures, currencies, bonds and funds from a single integrated account for US-listed stocks and ETFs and the lowest commissions on stocks, options, futures, currencies, bonds and funds from a single integrated account. IBKR Pro clients access the IB SmartRoutingSM system, which provides $0.47 per 100 shares price improvement vs. the industry.
Unlike other brokers with separate bank accounts in which you have to transfer cash back and forth, IBKR’s cash management is integrated into your broker account. This means that you can always borrow at the lowest rates without having to worry about first transferring cash.
When placing your money with a broker, you need to make sure your broker is secure and can endure through good and bad times. IBKR’s strong capital position, conservative balance sheet and automated risk controls are designed to protect IBKR and their clients from large trading losses.
Best for Retirement Savers: Vanguard
Vanguard was offering index funds back when most of the industry was still ridiculing them. As a leader in the industry, Vanguard offers several funds that provide exposure for the investor that meets their needs. There are no cookie-cutter funds at Vanguard.
Today, Vanguard is still the ideal spot for retirement savers thanks to its wide index fund selection, low-fee accounts and top-notch customer service. You can choose from funds like the Balanced Index Fund (VBIAX), Communication Services Index Fund (VTCAX) or Consumer Discretionary Index Fund Admiral Shares (VCDAX).
You’ll never pay a fee to trade exchange-traded funds (ETFs) or mutual funds, even ones from other companies. Certain mutual funds do have load and redemption charges, so be sure to confirm the fee schedule before making any investments. Vanguard has low margin rates (ideal for index investors) and a wealth of educational material on retirement saving.
Best Low-Cost Robo Advisor: Betterment
Betterment is the main competition for Wealthfront and while it doesn’t have the full suite of banking services, it does have lower fees. Think of Betterment as the Vanguard of robo-advisors.
As a robo advisor, Betterment will charge 0.25% annually on money invested. The platform invests in index funds with expense ratios as low as 0.03%. Traditional and Roth IRA accounts are available as well as banking services, but the checking account pays a lower APY than Wealthfront’s (0.30% vs 0.35%).
Best for Research and Tools: TD Ameritrade
Index funds may not have active managers, but that doesn’t mean they can’t be actively traded. If you’re looking to flip index funds based on economic trends and technical signals, TD Ameritrade is the broker for you.
Research reports from Morningstar, Dow Jones, Argus and Market Edge are available to Ameritrade clients. You’ll also get the powerful Thinkorswim platform, which can analyze complex trading data and provide better entry and exit points. Plus plenty of tools for options trading (because index funds aren’t just for the risk-averse!)
Best for Zero Cost Offerings: Fidelity
Most online brokers have completely removed commissions, including Fidelity. But commission isn’t the only fee paid by investors. Mutual funds and ETFs all have expense ratios that take a minor cut out of investor capital for the pleasure of holding the fund. The fees are small, usually between 5 to 10 basis points, although they can get larger when tracking less liquid indices.
However, Fidelity offers funds that truly have zero cost. As in an expense ratio of 0.0. Yes, zero point zero. Take the Fidelity ZERO Total Market Index Fund (FZROX), which can be bought and sold without commission or load charges on Fidelity. You won’t pay a penny to own the fund at any point in your investment. Fidelity is a worthwhile broker for investors of all skill levels thanks to its impressive array of research and trading tools.
What is an Index Fund?
Vanguard founder John Bogle is thought to be the progenitor of modern index funds. Bogle noticed that the large majority of mutual fund managers who actively picked stocks failed to beat market averages. Some years would be good and others bad, but very few could consistently beat the returns of the S&P 500. Of course, investors would pay the manager the same fee in good years and bad, too.
Instead of paying fund managers to try and beat the market, why not slash those fees and simply invest in an index like the Dow or S&P 500? Unlike other mutual funds that actively pick stocks based on a specific theme or strategy, index funds buy and sell stocks based on their position in the index, usually with a market cap or stock price as the weighting methodology.
Bogle figured (correctly) that over a long time horizon the index investors would outperform investors in actively managed funds simply by taking the market average and compounding the money they save on fees. Bogle introduced the first index fund in 1976, which still trades today under the name Vanguard Index Trust 500 (VFINX) and has nearly $700 billion in assets.
Pros and Cons of Index Funds
|Cheaper on average than actively managed funds||Investors accept market returns; no alpha or outperformance|
|More liquidity than actively managed funds||Tracking errors may cause the fund to detach from the corresponding index|
|More tax-efficient because index funds buy and sell securities less frequently than active managers||Less flexible than actively managed funds since rules must be followed to remain as close to the index as possible|
How Does an Index Fund Work?
An index fund works pretty much like your standard mutual fund or ETF, just without the active manager selecting securities by hand. One of the most popular ETFs on the market today is the Ark Invest Innovation ETF (NSDQ: ARKK) run by the current ‘belle of the bull’ Cathie Wood. Wood actively selects the stocks for her fund, choosing to buy shares when she personally sees an opportunity.
Index funds are the opposite of ARKK. The manager of an index fund isn’t trying to get a leg up on the competition, they simply want to match the underlying index as closely as possible. Index funds buy and sell shares based on the weights of the shares in the index. For example, SPY tracks the S&P 500 and weights the holdings by market cap. Right now, Apple (NYSE: AAPL) is the largest company in the S&P 500, so it’s also the largest holding in the SPY portfolio.
Types of Index Funds
Index funds track their underlying indices in two primary ways: market cap weighting and price weighting. The S&P 500 is a market cap-weighted index; the companies with the largest market caps hold the most weight. In contrast, the Dow Jones Industrial Average is price-weighted — the higher the price of the stock, the more weight it holds in the index.
- Sector Index Funds: Certain index funds concentrate only on certain sectors, like financials or healthcare companies. For example, XLF is an ETF that tracks the Financial Select Sector Index composed of the largest banks and financial firms in the United States.
- Regional index funds: Like sector index funds, only grouped by region or country instead of industry.
- Index funds by market cap: One of the most common ways to break up index funds is by market cap. Large-cap stocks and small-cap stocks each have their own indices that are tracked by different funds.
- Index funds by strategy: Are you a growth or value investor? Whichever way you answer, there are index funds that track stocks based on your investing strategy.
Index Funds Should be a Staple for any Investor with a Long Time Horizon
Index funds might not be exciting or carry the promise of outsized returns but can be the bedrock of a long-term portfolio. Index funds are affordable, tax-efficient, and you won’t have to worry about underperforming the market since the market’s return is all you’re expecting.
These funds have provided simple retirement vehicles for millions of Americans who don’t have the time to check the markets each day or simply don’t understand the ebbs and flows of market fluctuations. If you want to set and forget your investments, index funds are the choice.
Frequently Asked Questions
What is an index fund and how does it work?
Index funds are low-cost vehicles that pool investor money together to invest in a wide range of stocks. Unlike active funds, index funds simply track an underlying index in an attempt to match its performance.
Are index funds good for beginners?
Yes! Index funds are an ideal first investment because they’re low risk, low cost and easy to understand. Most people begin the investing journey buying index funds for a retirement account.