By David Carlson/ Last updated: /Investing, Personal Finance
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In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
I think this is a good trend, as I practically beg new investors to keep it simple.
The easiest way to keep it simple is by not investing in individual stocks. There are also way too many investors getting ripped off by the high fees that come with actively managed funds, a majority of which do not outperform a passive index over the long-term.
To new investors this jargon can be confusing.
I was telling a friend recently about index funds, and I got a blank stare. He jokingly said, “index cards? Is that what you are talking about?”
Investing can be intimidating because of how some people over-complicate it. If you watch “Made Money” you would think stock picking is something everyone should be doing. In reality, most investors – and certainly new investors – would benefit from focusing on low-cost index funds that track the broad stock market.
Let’s start by answering the question: what is an index fund?
Index Funds Explained
Index funds are mutual funds or Exchange-Traded Funds (ETFs) set up to track the performance of a benchmark index, such as the S&P 500. Said differently, they move up or down in price based on a large basket of stocks. This is beneficial because you spread your exposure across many companies. Compare that to investing in only a handful of individual companies. If one of those companies failed and went bankrupt, a large portion of your investment portfolio would be wiped out. With an index fund exposure is spread out across many, many companies, reducing your exposure and risk related to any one company.
Many index funds are capitalization weighted, or cap-weighted, which means that the larger components are given a larger weighting. For example, if you look at the Fidelity total stock market index fund you will see that the top holdings are, among other large companies, Microsoft, Apple, Amazon, and Facebook. The reason they make up a higher percentage than say, a small company whose market capitalization is only $10 million, is because having the same exposure to Apple as a $10 million company would give too much exposure to the small company.
Index funds are passively managed, meaning there is not a fund manager trying to “beat the market.” This allows the funds to have low fees, sometimes as low as 0.00% (for example, Fidelity’s total stock market index fund FZROX). The problem with actively managed funds is that they not only have to beat a benchmark index, but they also have to beat the index plus the fee they charge, which can be as much as 2% or more.
Here are a few examples of index funds. Notice the low fees charged.
Fidelity ZERO Total Market Index Fund (FZROX)
Objective (from the Fidelity website): The fund seeks to provide investment results that correspond to the total return of a broad range of U.S. stocks.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.00%
Minimum Investment: $0
Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Objective (from the Vanguard website): Designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks..
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.04%
Minimum Investment: $3,000
Vanguard Total Stock Market ETF (VTI)
Objective (from the Vanguard website): Vanguard Total Stock Market ETF is an exchange-traded share class of Vanguard Total Stock Market Index Fund, which employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.03%
Minimum Investment: Cost of 1 Share is approximately $150
You can find a lot of index fund options at both Vanguard and Fidelity. Vanguard has made a name for itself in the low-fee index fund space, and many investors use them. Fidelity has recently rolled out more options for index fund investing as well.
Resources and Tools for New Investors
To invest you need positive cash flow that can be diverted to index funds. I wrote a post outlining 5 ways to find cash to invest in the stock market that may be helpful if one of your goals is to invest more.
I also created a spreadsheet you can use to quickly and easily analyze your 401k or 403b investment options. You can grab a free copy here.
Bottom line on index funds: Index funds offer investors the benefit of low fees and lower risk due to broad exposure to the market.
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"Index funds are a low-cost way to track a specific group of investments, which can be more broadly diversified than individual stocks and simpler to buy than each of the individual holdings within the index," she said.
An index fund is a type of mutual fund or exchange-traded fund that aims to mimic the performance of an index, such as the S&P 500®. Index funds tend to offer investors lower costs and taxes than some other types of funds. They're also relatively lower maintenance.
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
Index funds are often more tax-friendly than similar active funds. Since index funds are passively managed, with no active security selection, this often makes them cheaper than similar actively managed funds. They are able to charge lower fees to investors.
Index funds hold investments until the index itself changes (which doesn't happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.
The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after.
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
An index fund usually owns at least dozens of securities and may own potentially hundreds of them, meaning that it's highly diversified. In the case of a stock index fund, for example, every stock would have to go to zero for the index fund, and thus the investor, to lose everything.
Short-term downside risk: Index funds track their markets in good times and bad. They can be volatile places to put your money, especially when the economy or stock market isn't doing particularly well. When the index your fund is tracking plunges, your index fund will plunge as well.
Even the top investors put their money in index funds. Some of the wealthiest people in the world are professional investors. Billionaires like Warren Buffett, Ray Dalio, Bill Ackman, and Ken Griffin have made their fortune by getting others to invest with them and making smart investments.
The first is the lower risk — because an index fund features a wide collection of stocks, it's naturally diversified. You aren't putting all of your eggs in one basket, and you don't have to worry about losing your entire investment if one company fails.
Our recommendation for the best overall S&P 500 index fund is the Fidelity 500 Index Fund. With a 0.015% expense ratio, it's the cheapest on our list. And it doesn't have a minimum initial investment requirement, sales loads or trading fees. Over the last 10 years, FXAIX has returned an annualized 12.02%.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.
Like stocks, you invest in an index fund by purchasing individual shares. You then own a percentage of the overall portfolio equivalent to how many shares you bought and are entitled to the fund's returns on that pro-rata basis. For example, say that the ABC Fund releases 50% of its value in the form of 100 shares.
How much is needed to invest in an index fund? The minimum needed depends on the fund and your broker's policies. If your broker allows you to buy fractional shares of stock, you may be able to invest in index fund ETFs with as little as $1. If not, your minimum investment will be the cost of one share of the ETF.
Capital gains taxes on that sale are yours and yours alone to pay. To get cash out of an index fund, you technically must redeem it from the fund manager, who will then have to sell securities to generate the cash to pay to you.
An “index fund” is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.
Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually.
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In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
