How to Invest in Index Funds – NerdWallet (blog)

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Everyone gushes about index mutual funds, and for good reason: They’re an easy, hands-off, diversified, low-cost way to invest in the stock market.

When investors buy an index fund, they get a well-rounded selection of many stocks in one package without having to purchase each individually. And because these funds simply hold all the investments in a given index — versus an actively managed fund that pays a professional to do the stock picking —  management fees tend to be very low. The result: Higher investment returns for individual investors.

Lastly, index funds are easy to buy. Here’s how it’s done.

1. Pick a benchmark index

The Standard & Poor’s 500 index is one of the best-known indexes because the 500 companies it tracks include large, well-known U.S.-based businesses representing a wide range of industries.

But the S&P 500 isn’t the only index in town. There are indexes — and corresponding index funds — composed of stocks or other assets chosen based on:

  • Company size and capitalization (as in small-, mid- or large-cap indexes)
  • Geography (focusing on stocks that trade on foreign exchanges or a combination of international exchanges)
  • Business sector or industry (consumer goods, technology, health-related businesses, for example)
  • Asset type (domestic and foreign bonds, commodities, cash)
  • Market opportunities (emerging markets)

Despite the array of choices, you may need to invest in only one. His Royal Investment Highness Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified.

However, those who want additional exposure to specific markets in their portfolio (more emerging market exposure? a higher allocation to small companies or bonds?) can easily customize their allocation.

2. Compare fund management fees

Low costs are one of the biggest selling points of index funds. They’re cheap to run because they’re automated to follow the shifts in value in an index. But even though they’re not actively managed by a team of well-paid analysts, they carry administrative costs.

Those costs — the main one is the expense ratio — are subtracted from each fund shareholder’s returns as a percentage of their overall investment. Find the expense ratio in the mutual fund’s investor prospectus or when you call up a quote of a mutual fund on a financial site.

For context, here were the average asset-weighted annual administrative expenses for actively managed and index mutual funds in 2016, according to a report from the Investment Company Institute.

Sources: Investment Company Institute, Lipper, Morningstar

Typically, the bigger the fund, the lower the fees. But don’t assume that all S&P 500 index mutual funds are cheap. While two funds may have the same investment goal, management costs can vary wildly. Those fractions of a percentage point may seem like no big deal, but investment returns can take a massive hit from the smallest fee inflation. The money taken out to cover costs means the opportunity for it to grow — for the compound interest snowball to gain momentum over time — is lost forever.

3. Consider potential tax issues

Another cost to consider is the tax-cost ratio, which is how much owning the fund may trigger in annual taxes. This is important if you’re investing in a taxable account as opposed to an IRA or a 401(k).

Transactions within a mutual fund — when stocks are bought or sold or when companies distribute dividends — can generate capital gains taxes. Like the expense ratio, these taxes can take a bite out of investment returns. This is typically an issue with actively managed funds where investors sacrifice 0.75% in average annual returns versus just 0.30% in returns when invested in an index fund, according to a 2014 study by Vanguard founder John Bogle.

Like with expense ratio, don’t assume that just because it’s an index fund the tax tab is going to be low. Fund tracker Morningstar calculates the tax-cost ratio, which shows the percentage by which a funds performance has been reduced by taxes.

4. Make sure returns closely match the index

The index fund’s returns are on the mutual fund quote page. It shows the index fund’s returns during several time periods, compared with the performance of the underlying benchmark index.

Don’t panic if the returns aren’t identical. Remember, those investment costs, even if minimal, affect results, as do taxes. However, red flags should wave if the fund’s performance lags the index by much more than the expense ratio.

5. Check the fund’s investment minimum

Yes, we’re back to costs again. This time it’s the cover charge, or the investment minimum required to get in the door. It can run as high as a few thousand dollars. Once you’ve crossed that minimum threshold, most funds allow investors to add money in smaller increments.

Mutual fund companies like Vanguard and Fidelity set their own fund minimums, which also dictates the amount that brokers who carry their funds require customers to commit to upfront. If the minimum is out of your reach, don’t be deterred. It can be worth it to pay a slightly higher expense ratio temporarily to get started and later transfer to a less-costly fund when you’ve accumulated the minimum.

Another workaround — and an easy way to start index investing when you don’t have a lot of money — is to invest in an exchange-traded fund (ETF) that tracks an index. ETFs are like mini mutual funds that trade like stocks throughout the day. Instead of having to buy the main-course mutual fund, you purchase a slice of the fund. (Here are some pros and cons of investing in ETFs vs. mutual funds.)

6. Decide how to buy

You can purchase an index fund directly from a mutual fund company or through a discount brokerage account. The same is true for ETFs. (If you want to cut to the chase, see which providers we chose as the best brokers for mutual funds and best brokers for ETFs.)

When you’re choosing where to buy an index fund, consider:

  • Fund selection. Do you want to purchase index funds from various fund families? The big mutual fund companies carry some of their competitors’ funds, but the selection may be more limited than what’s available in a discount broker’s lineup.
  • Convenience. Can a single financial service provider accommodate all your needs? For example, if you’re just going to invest in mutual funds (or even a mix of funds and stocks), a mutual fund company may be able to serve as your investment hub. But if you require sophisticated stock research and screening tools, a discount broker that also sells the index funds you want may be better. Having accounts at several institutions may be just fine if, for example, you want to consolidate all of your retirement funds in one place and use another firm for other investment needs.
  • Account minimum. This is different than the investment minimum. Although an account minimum may be $0 (common for customers who open a traditional or Roth IRA), that doesn’t remove the investment minimum for a particular index fund.
  • Commission-free options. Do they offer no-transaction-fee mutual funds or commission-free ETFs? This is an important criterion we use to rate discount brokers. (The selections at Charles Schwab, E-Trade, Fidelity and TD Ameritrade are worth checking out.) Note that investors may be required to hold a commission-free mutual fund or ETF they buy from these lists for a minimum period — usually about 30 days — to avoid paying a short-term trading penalty.
  • Trading costs. If the commission or transaction fee isn’t waived, consider how much a broker or fund company charges to make the trade. Mutual fund commissions are higher than stock trading ones, about $20 or more, compared with less than $10 a trade for stocks and ETFs.

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