Thursday, 26 November 2020

How to Invest in Index Funds

How to Invest in Index Funds
06 Dec
12:10

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Few investment products become popular enough to make it into the general lexicon, but everyone seems to be talking about index funds these days. Index funds have doubled their share of asset management dollars since the financial crisis of 2008 ended, and they could surpass actively managed mutual funds in popularity as soon as 2024, according to Moody’s Investors Service. Even Warren Buffett, one of history’s most successful active investors, regularly touts index funds as the only strategy the average investor really needs.

Despite the buzz, index funds are not the most exciting investments at first glance. They are passive and powered by a computer model — without a manager attempting to pick winning holdings or to get rid of losers when they are down. Instead, an index fund tracks the performance of a set group of companies included in a major market index and produces returns in line with that benchmark.

An S&P 500 index fund, for example, provides exposure to the 500 largest publicly traded companies in the U.S. that make up the S&P 500. It’s like buying the performance of the benchmark U.S. stock market — and at a very low cost. With an index fund, you generally won’t outperform or underperform a given market, as you own the market.

Why investing in index funds has become so popular

While they may not be the kinds of investments you brag about, index funds consistently outperform hot-shot actively managed mutual funds over time.

Here are four reasons passive investing is winning out.

Index funds are low-cost

“One of the major factors to investing success is fees,” said Joseph A. Carbone Jr., a certified financial planner with Focus Planning Group in Bayport, New York. Lower fees help boost performance in any market because you are losing less of your investment to the cost of the fund. Without an expensive fund manager to pay, index funds charge an average annual expense ratio of 0.09%, compared to an average of 0.59% for actively managed mutual funds, according to the Investment Company Institute. At the extremes, Fidelity, the giant broker typically known for its actively managed mutual funds, offers no-fee index funds. Actively managed funds can charge as much as 2.5% in annual expenses, not including added sales charges.

Index funds are consistent

Mutual fund managers are sometimes guilty of “style drift,” or diverging from intended investment categories, which can impact the fund’s underlying asset allocation and risk profile. With index funds, the investments are set, so there is no risk of drift.

Active management isn’t adding value

For the past 15 years ending in June 2018, 92.43% of large-capitalization mutual fund managers, 95.13% of mid-cap managers and 97.70% of small-cap managers failed to outperform index benchmarks on a relative basis, according to midyear data from SPIVA. With those odds, why pay a stock or bond picker in an attempt to beat the market?

There are tax advantages to investing in index funds

“Passively managed investing is a lot more tax-efficient than actively managed,” said Carbone. Managers are able to buy and sell assets to take advantage of market opportunities, but that trading creates taxable capital gains, which can be a drag on performance. Because indexes generally shift infrequently, trading within index funds happens a few times a year at most.

What are the downsides to index funds?

Plenty of professional investors will tell you that index funds have their downsides. Here are a few of the most common arguments.

Index funds aren’t strategic

Many of the strategies that fuel market success stories — stock picking, concentrated positions, value investing, hedging — are not as easy to index.

They don’t weather downturns

Unlike a mutual fund, an index fund is not able to react when markets turn volatile. This should help actively managed funds handle downturns better than nonreactive index funds.

According to a 2018 analysis by Morningstar, the odds of an active U.S. equity fund beating its benchmark are almost twice as good during “down” market periods, regardless of asset class. It also found that funds that beat the benchmarks during down periods do so by a wider margin than in “up” markets. However, that performance was not sustained, and those funds that did well during a single three-year period tended do badly the following period.

Index funds may not be best for every asset class

OK, so maybe a manager can’t add value in the large domestic stock market, which is so well covered by analysts that there’s virtually no way to have an edge on other investors. But what about, say, small-cap international stocks? Surely there are managers who can uncover something there or in similar markets we don’t know much about.

For some years, this is true. In 2017, 55% of managers in foreign large-cap blend and diversified emerging markets funds beat their benchmarks, up from 36% in 2016, according to Morningstar. Active U.S. small-cap managers did well in 2017 too, with 48% of them beating their benchmarks, up from 29% in 2016. “In theory it makes sense, but the numbers don’t bear this out,” said Carbone. Over the long term, however, asset managers lag significantly in most asset classes.

They can be boring to some people

If your idea of fun is buying individual stocks in the hope of finding the next Apple or Netflix, index funds probably are not your speed. On the other hand, some financial advisors prefer index funds because they feel like less of a gamble than other investments.

Index funds vs. mutual funds vs. ETFs

Mutual funds are actively managed, while index funds are passive. Otherwise, the two investments are fairly similar. Then there are exchange-traded funds (ETFs), which are index investments that trade on the stock exchange.

How to make sense of it all? Here’s a chart to help you compare the differences.

  Mutual Fund Index Fund ETF

What is it?

A pool of money through which large groups of investors can own a variety of stocks, bonds or other assets strategically selected by an asset manager or management team.

A pool of money through which large groups of investors can track the performance of a stock or bond market index. An index fund is a type of mutual fund without a manager.

A security that tracks the performance of a stock or bond market index or selection of assets. Think of an ETF as an index fund-stock hybrid.

How often can you trade?

Once a day at net asset value (NAV) or daily share price.

Once a day at net asset value (NAV) or daily share price.

All day at intraday share price.

Where can you buy it?

Purchase directly from a mutual fund company or through a broker.

Purchase directly from a mutual fund company or through a broker.

Trade shares on the stock exchange through a broker or online brokerage account.

How do you pay for it?

Through an ongoing expense ratio or percentage of assets. The average expense ratio for equity mutual funds is 0.59% per year. Some mutual funds have sales loads or commissions paid when you buy or sell shares.

Through an ongoing expense ratio or percentage of assets. The average expense ratio for index equity funds is 0.09% per year.

Through an ongoing expense ratio or percentage of assets. Index equity ETF expense ratios average between 0.20% and 0.50%. There are also trading fees when you buy and sell.

What’s the minimum investment?

Typically $500 to $3,000. Fidelity has no minimum investment funds.

Typically $500 to $3,000. Fidelity has no minimum investment funds.

None, other than the cost of a share plus the cost to trade it.

Source: 2018 Investment Company Fact Book

Carbone uses ETFs to build portfolios for clients but doesn’t always recommend them for the individual investor. “There’s a lot less that can go wrong when you’re purchasing a mutual fund or index fund versus an ETF.” said Carbone. “A mutual fund is much more user-friendly.”

How to select an index fund

Ready to invest in an index fund? These three steps can get you started.

1. Find a fund company

You can purchase an index fund directly from a mutual fund family, such as Vanguard, the company that pioneered index funds. Firms such as Schwab and Fidelity offer index funds and are large enough to offer products to handle all your investment needs. Keep in mind that index funds don’t really vary from firm to firm. So look for a provider with a good reputation for offering low-cost, no-load funds.

You also can purchase an index fund through a broker, and some discount brokerages will trade mutual fund shares without a transaction fee. If you still can’t decide, compare a couple of options and pay attention to things such as the expense ratio, minimum initial investment and account minimum. Vanguard and Schwab both offer a wide range of low-cost index products with relatively low minimums. Fidelity offers a handful of no-fee, no-minimum accounts, but the fund giant still makes its money through active investing.

2. Select your index

A recent finding by the Index Industry Association found that there are almost 3.3 million stock indexes around the world.

Where is a good place to start? Buffett recommends a simple S&P 500 index fund for the average investor. Or you can get even broader exposure through the total-market Wilshire 5000. Looking for just small caps? The Russell 2000 represents the smallest U.S. stocks. Looking for global exposure? The MSCI global equity index is popular with international investors.

You also can choose between equal-weighted and market-weighted index funds. Market weighted means the companies are represented according to their market value, with the largest companies representing a greater portion of the index. With an equal-weighted index, all companies are represented equally. Each strategy has its benefits: Market weighting tracks more closely to the market’s performance, but equal weighting helps reduce your risk and tends to outperform over time.

3. Balance your assets

Should you buy just one, or is it better to buy multiple index funds? For investors who want to keep things simple, a single broad domestic index fund, such as an S&P 500 fund, is a good start. But if you’re ready to diversify, you can build a world-class equity portfolio with as few as three index funds, said Carbone.

Start with an S&P 500 and add an international equity stock index, such as MSCI, he said. “This gives you global diversification.” For a bond portion, Carbone recommended a Barclays investment-grade bond index fund, a common benchmark for bonds.

How much you put into each fund will depend on your own goals and risk tolerance, but the three components represent all the diversification you need at a combined cost of less than one percentage point.

Bottom line

Any active manager or investment trader will tell you that outperforming the market is not easy to do. Take fees into account, and an active manager has to work even harder to beat a passive investment. So why not consider jumping on the index fund bandwagon? This is one popularity contest investors can win.

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Melissa Phipps

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