Would index funds be as popular if Warren Buffett hadn’t endorsed them? Who knows? Maybe not. Index funds, which consist of a mutual fund or ETF portfolio that track a broad segment of the U.S. stock market, offer access to low-cost, diversified portfolios.
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Index funds at a glance
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. Watch as Warren Buffett explains why index funds are a great choice for the average small investor:
Why we like index funds
“Bogle’s Folly” was the assigned nickname of the very first index mutual fund, which launched Aug. 31, 1976 by Vanguard founder Jack Bogle. Later, “Bogle’s Folly” was, in fact, proven genius: buying and holding a broad selection of the stock market turns out better results than picking stocks.
Even though we’ve heralded their triumphs here, the pros and cons of a particular index fund should be carefully considered before you run out and buy one.
Pros of index funds
- 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 number 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.
Cons of index funds
- 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 invest in index funds
We recommend the following steps in order to choose and execute the purchase of an index fund:
1. Know which index the fund follows
Since indexing has become so popular (especially among ETFs) picking an index fund isn’t as easy as it used to be, when there were fewer to choose from. Before you ultimately select an index fund, understand its underlying holdings and how it’s behaved in the past (past performance is no guarantee of future performance, though!)
Also, is the fund specialized and specific? If so, do thorough research to make sure you understand what you’re putting your money into. Specialized funds can be more “slippery” than mainstream index funds. Triple check to be sure that a fund you’re considering really does track an index.
2. Choose where you’d like to buy your index fund.
There is an endless number of options for where to buy index funds. Most discount brokerages offer them, so it’s a matter of checking out Benzinga’s investing guides.
3. Learn about fund fees and tax effects
Contrary to popular belief, not all index funds are tax efficient, and not all index funds are cheap. It’s imperative that you figure out how much a potential index fund will cost you. All fee information is available on a broker’s website.
4. Decide how much you’d like to invest
This part is an intensely personal decision. You’ll need to weigh how much you can invest against the fund minimums.
Future outlook for index funds
According to Moody’s, the credit rating company, by 2024, index funds will take over more than half the assets in the investment-management business. Moody’s stated that investors are increasingly buying index funds and will eventually take the lion’s share of the market over active funds. According to Morningstar, Inc, two years ago, investors spent $506 billion on passive funds and $341 billion on actively managed funds.
The point is, index funds aren’t going away any time soon, and the results are in: Investors aren’t keen to part with their money in the form of fees and taxes. For an easy-to-understand lecture on active vs. passive investing, check out this video: Note: It’s a unit trust company from South Africa that put the video online, but it’s a great one for beginners to understand the differences between active and passive.
Index funds have a promising future, though for every “Index funds are great!” message you’ll hear in the media, there’s the opposite message. “You can’t react to the market. You have limited choice over holdings. You aren’t allowed to determine strategy.”
There are others, just Google them. It’s true they may not be right for every investor. And true, there are excellent money managers out there who do beat the market. It’s you deciding for yourself what your goals are that will help you make your decisions.