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Index funds have become the premier investment vehicle over the last 20 years.
They now house well over 4 trillion USD—that's more than active funds.
It’s easy to see why: index fund holders achieve market returns with minimal time/effort.
The remaining market participants compete to earn about 1% below these market returns after fees (and much less than that after short-term capital gains taxes).
Index funds aren't just for non-experts.
Investing gurus like
Ray Dalio invest heavily in index funds, as evidenced by
13F filings.
Warren Buffett doesn’t give many stock tips, but he has recommended index funds and has even
instructed the trustee of
his estate to invest 90 percent of his money in an S&P 500 index fund.
What are index funds?
An index fund tracks the returns of a market index, which is a collection of assets.
An example is the S&P 500, which includes roughly 500 of the largest companies in the US.
By purchasing an S&P 500 index fund, you own a small share of all companies in this index.
When the S&P 500 goes up 10%, your fund will increase about 10%.
The S&P 500 is just one of hundreds of indexes you could invest in.
There are index funds for stocks and bonds targeting certain countries, regions, or even industries.
Below are some popular indexes.
A key consideration for indexes is the weighting method used.
The weighting method determines how much of each security is held by the fund.
For example, a stock index could weigh each stock equally.
A fund tracking this index would hold equal dollar amounts of each stock in the index.
The most common weighting method is market cap-weighting, described below.
Market cap-weighting
Most passive index funds are market cap-weighted.
This means they hold an amount of each asset proportional to the market cap of that asset.
The market cap is the value of all shares of that asset (the number of shares times the price per share).
If you buy the S&P 500 VOO
ETF, you’re buying a small (unequal) amount of each company in the S&P 500.
You're buying about twice as much Facebook stock as Bank of America stock because, at the time of this writing, Facebook has almost
double the market cap of Bank of America.
If that relationship flips in the next ten years (Bank of America becomes
twice as valuable as Facebook), so too will the holdings within VOO.
Let's consider an example market cap-weighted index fund with 3 companies A, B and C with
market caps of 6B, 3B, and 1B USD, respectively.
If you purchase 1,000 USD of this index fund, you are investing 600 USD in company A, 300 USD in company B and 100 USD in C.
If the value of company C doubles—while the others do not change—your 1,000 USD investment will now be worth 1,100 USD.
You now hold 600 USD of company A, 300 USD of company B and 200 USD of C.
Aside from being a straightforward strategy, market cap-weighting reduces costs by minimizing trading.
Even commission-free trades can be costly (e.g. due to buy/sell spreads).
To see this, consider the example index above.
Once company C doubled in value, the associated number of shares
of A, B and C held by the index fund did not need to change.
The value of the shares of C doubled, that's what caused the market cap to double.
Hence, no action needs to be taken—the fund automatically retains its cap weighting.
Consider an alternate index fund that instead holds equal dollar value in A, B and C (i.e.
equal-weighting instead of market cap-weighting).
This fund would need to continuously sell shares
of C (and buy shares of A and B) when C outperformed.
If not, they’d end up with more money invested in C than A or B.
Market cap-weighting has some critics.
While it has performed extremely well recently, it can cause a lack of diversification.
In the case of the S&P 500, the top 5 names—Apple, Amazon, Facebook, Alphabet and Microsoft—represent
almost a quarter of the entire index!
Some people are not comfortable investing such a large amount in just 5 companies, particularly when they are in roughly the same industry.
Comparing funds
A variety of funds are available to track most indices.
Some are
mutual funds
and others are
exchange-traded funds (ETFs).
Even within the ETF (or mutual fund) category, you'll find multiple providers like Vanguard, Fidelity and Schwab.
Below, we discuss some factors to consider when selecting a fund.
Fees
One of the most important rules when selecting a fund is to avoid high fees.
Check the expense ratio and
tax-cost ratio
of comparable funds to be sure you're not overpaying.
Look here for more information on how seemingly small fees add up over time, you may be shocked.
For example, a 1% fee can easily add up to hundreds of thousands of dollars over a long term investment horizon.
Of course, the brokerage you purchase the fund through may assess commissions/fees as well.
The index funds we discuss/list on our site have been scrutinized and should have the lowest (or comparable to the lowest) fees in their category.
If not, please
let us know. We do not list funds for commission
or any other type of compensation.
Minimums
There's typically a minimum amount required to invest in an index fund.
For ETFs this may be around a hundred dollars or less, but for mutual funds this
can be thousands of dollars.
Tracking error
For practical reasons, the funds cannot perfectly track the index as intended.
In practice, this “tracking error” is usually negligible.
To be sure, check the returns of the fund. They should be within about 0.2% of the index (minus the expense ratio).
Before investing
Before purchasing a fund, it's best to read the fund's (1) prospectus,
(2) most recent shareholder report, and/or (3) the most recent quarter portfolio holdings.
All of this information is available in
EDGAR.
This information will disclose all fees associated with the fund, risks and the investment strategy.
Warnings
Like individual stocks or bonds, index funds have no built-in safety net.
If the S&P 500 drops 20% tomorrow, an associated index fund like
VOO will lose about 20%.
There’s nobody watching the market for you and trying to sell before a crash.
On average, this is beneficial—market timers mostly lose money by not being in the market.
A risk of corruption exists, primarily in smaller, less known indices.
The committee (or individual) that selects what securities are included in an index can increase/decrease
the value of companies by adding/removing them from the index.
This effectively redirects money in the associated index funds.
This phenomenon is probably much more prevalent in actively managed funds, however.
Summary
For the most part, index funds are very beneficial to an investor.
We owe a debt of gratitude to
John Bogle and others who made these products.
Because of their passive, cap-weighted strategy, they typically incur minimal
fees and taxes while providing
good diversification (within the market of the tracked index).
After accounting for taxes and fees, actively managed funds
almost always lag the returns of index funds.
However, we want our readers to be aware of the potential problems listed below.
Not all index funds have low fees, however, and it's up to the buyer to ensure she/he is not getting ripped off.
Choice index funds
Below is a short list of index funds that we find attractive.
We prefer these based on a combination of low fees, liquidity and diversity of holdings.
We are not compensated in any way for these recommendations.
All of these funds are cap-weighted.
- VXUS - Almost all stocks listed outside the US
- VT - Almost all stocks in the world
- VWO - Emerging market stock
- VBR - US small cap value stock
- VTI - Almost all US stocks
More information
For more information, please read the
information provided by the US Securities and Exchange Commission (SEC).
You can also read NerdWallet's article
""How to invest in index funds."
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