Legendary investor Warren Buffet of Berkshire Hathaway swears by index funds. He has argued that this is the best investment option for younger and first-time investors and even for seasoned ones because trying to outperform the market is a futile pursuit. There are many advantages to investing in index funds. There are also specific index funds available through pooled funds like exchange-traded funds, mutual funds, and unit investment trusts that have notable performances. This article provides a definitive guide to selecting or choosing an index fund.
Basics of Index Funds: The Ultimate Guide to Choosing an Index Fund for Beginners
The notable advantages of investing in index funds revolve around convenient investing, ease of entering the stock market or bond market, lower cost compared to actively managed funds, and suitability to a buy-and-hold long-term investment strategy. However, when it comes to selecting one, there are wide options to choose from. There are also different financial services firms or fund management companies that offer them.
It is important to note that an index fund tracks and replicates the performance of a particular market index. Examples include the S&P 500 which includes top-performing stocks in the United States stock market and CAC 40 which includes European stocks traded in Euronext Paris. There are also index funds based on market capitalization like a particular basket of stocks composed of large-cap, mid-cap, or small-cap stocks.
Remember that a particular index fund includes a basket of securities that were selected based on the index the fund intends to track and replicate. Investing in such gives an investor efficient market coverage. The main challenge is in selecting a particular index fund from varied options from various financial services providers. The following is a step-by-step guide to investing in an index fund for beginners and even seasoned investors:
Step 1: Define Investment Goals
Different investors have different purposes for investing. The younger ones might want to invest to raise money for big-ticket expenses in the future. There are also those who want to invest to build their retirement funds or the education funds of their children. Some invest because they have disposable income to spare and want to place their extra cash in vehicles that can provide better potential returns compared to saving in banks.
Nevertheless, when it comes to index fund investing, the first step to selecting a particular index fund is to define an investment goal or investment. This goal should take into consideration the general purpose of investing, the ideal investment horizon, and the risk appetite as determined by some suitability assessment. It is important for an investor to define his or her investment goals to determine the best index fund to invest in.
Step 2: Select an Asset Class
There are two common types of asset classes that comprise index funds. An equity index fund is composed of stocks of public companies while a bond index fund is composed of bonds issued by governments and corporations. It is important to remember that a particular index fund only invests in either of the two. A fund that invests in both is either a mixed fund or a balanced fund. These funds do not track a particular market index.
Stocks represent ownership in companies. They offer higher growth potential but come with higher risks. They also come in different classifications. Bonds represent loans to governments and companies. They provide a guaranteed income stream and lower or lesser risks but also have a lower potential for substantial growth. An investor who understands his or her goals in investing will not have a problem in selecting an asset class.
Step 3: Choose an Index to Track
The next step in selecting an index fund is to choose which index to track. There are different market indexes to follow. Furthermore, if an investor chooses stocks as his or her preferred asset class, then he or she should choose an index that tracks a particular stock market index. There are also different categories of indexes classified based on composition. These are broad indexes, sector indexes, country indexes, and style indexes.
Examples of broad indexes are S&P 500, Dow Jones Industrial Average, and Nasdaq Composite. Russel 2000 and S&P SmallCap 600 track small-cap stocks. MSCI EAFE and MSCI Emerging Markets track international stocks while CAC 40 and Hang Seng Index are country indexes that track companies respectively listed in the European Union and Hong Kong. Bloomberg Barclays Global Aggregate is a global bond and currency index.
Step 4: Evaluate and Choose an Index Fund
Another important step in selecting an index fund is evaluation. This involves using the same evaluation criteria used in other pooled fund options. There is at least one index fund that tracks the chosen market index. The S&P 500 has been tracked by dozens of index funds. One way to evaluate these funds is to read through their prospectus. Another is to use a fund screener and look for indicators that can help in comparing performance.
The most important criteria are expense ratio, tracking error, liquidity, and minimum investment. The expense ratio represents the percentage fee charged annually to manage the fund and the tracking error provides information on how the fund closely replicates the performance of the linked index. Liquidity represents the ease of entering exiting while minimum investment is the base amount that an investor must shell out to start investing.
Step 5: Select a Platform to Invest
For the final step, once an index fund is selected, the next process is to select the platform provider or broker that offers the fund. It is worth noting that the selected fund can be an exchange-traded fund, mutual fund, unit investment trust, and even an investment-linked universal insurance policy. Most brokers have online-enabled platforms that allow paperless and convenient transactions. An investor needs to open and fund a brokerage account.
BlackRock Funds, Charles Schwab, Fidelity Investments, and The Vanguard Group are investment management companies that offer index funds via their ETF and MF products via their online platforms. Interactive Traders, TD Ameritrade, and Trading 212 are brokerage platforms that trade ETFs. Note that fund selection and platform selection go hand-in-hand. Investors must also factor in related transaction fees in their decisions.