Index Fund Investing: How it Works And Best Funds

How index funds work

Investing can be a key part of building a successful financial future, and index funds can help you achieve those long-term investment goals. But how does index fund investing work?

It’s important to understand how index funds work before diving into this investment option. With that, let’s explore how index funds work today.

What is an index fund?

By Investopedia's definition, “an index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index".

In plain English, this means that an index fund can be set up to buy all the same stocks within a specific index like, say, the S&P 500; this means you will be invested in every single one of the 500 companies that make up the S&P 500.

Or you can purchase a total market index fund that invests your money in equal ratios across the entire stock market based on a total market index that measures the investment return of the overall stock market.

The key difference between an index fund and a mutual fund is that while an index fund simply tracks indexes, a mutual fund is based on stock holdings that are selected by a portfolio manager or fund manager who actively manages the mutual fund and charges you a fee for doing so.

How index funds work

An index fund works by following all of the stocks within a particular index. The fund is essentially passively managed based on the composition of a particular index. There are many different index funds that follow many of the numerous index funds available in the market today.

For example, if an index fund is following the S&P 500, it will continually mirror the stocks within that particular index. With that, the index will have all of the top 500 companies represented in the S&P 500 held in the index fund.

What is the advantage of investing in index funds?

When you are looking to invest in index funds, the positives can easily stand out. Here’s why investing with index funds is a good opportunity.

Lower costs

A portfolio manager or fund manager does not actively manage index funds. As a result, there are no high annual fees passed on to investors.

Most index funds have really low expense ratios of less than 0.05% of the fund's assets (paid to brokerage firms) which means you keep more of your returns in your pocket which can grow towards your retirement.

Returns follow the market

Outperforming the stock market is the goal and promise that many fund managers make with the funds they select and manage.

With index funds, you know what you are getting as you are simply tracking an index, so if the index rises 10% then your index fund will also rise 10% if the index declines 5%, then your index fund will also decline 5%.

Why is this a benefit? Well, based on a study done by Standard and Poors, "The majority of managers underperformed the benchmark".  The study shows a mutual fund that promises to outperform the stock market has a high chance of underperforming. Wouldn't you rather know what you are getting?

Diversification

By investing in a US total market index fund your money is invested across the entire US stock market. Now, how's that for diversification?

As an investor, you never want to have all your money in one single investment. The whole idea is to build buffers and minimize risk and index funds can help do this.

For broad diversification using index funds, you can consider the three-fund portfolio or the all-weather portfolio.

3 Best index funds with no minimums

Convinced that investing in index funds should be a part of your long-term strategy? Then take the time to consider some of the best index funds with no minimum investment requirements:

1. Vanguard S&P 500 ETF

Ticker symbol, VOO. Essentially this is the original index fund for the S&P 500. With that, the index invest in the stocks in the S&P 500, which are 500 of the largest public U.S. companies.

With no minimum investment requirement, you can get started with any investment amount. Plus, the low expense rate of 0.03% will ensure that you don't lose too much potential growth due to fees.

VOO will follow the increases and decreases in market value of the S&P 500. As an investor with a long-term horizon, this is a great option. You have the potential for long-term investment growth. However, the inherent volatility of the market makes it a risky choice for investors with a short-term mindset.

Vanguard's founder, Jack Bogle, invented index funds. With that, it is not surprising that the brokerage firm remains a leader in low-cost index funds.

2. Schwab S&P 500 Index Fund

Ticker symbol, SWPPX. You won’t need to meet a minimum investment in order to work with this fund. But the fees are still relatively low. In fact, this fund offers a lower expense ratio than VOO at 0.02%

SWPPX invests in the companies found in the S&P 500. With that, you'll be investing in a large swath of the market when you choose this option.

If you are looking for a long-term investment, then SWPPX is a good option with low fees and high potential returns. But a short-term investor should look for an investment opportunity with more predictability.

3. Fidelity Zero Large Cap Index

Ticker symbol, FNILX. The S&P 500 is not the only index with funds available. This fund is one of Fidelity’s options that tracks a different index - the large cap index fund.

As an investor, you'll need to decide for yourself what type of asset allocation you are comfortable with. Large-cap index funds can be an addition to diversify your investment portfolio.

With no minimum investment requirement and an expense ratio of 0.00%, FNILX is a good option if you want to invest in a large-cap index fund.

Of course, the best index fund for your situation will depend on your financial goals. It is important to include your personal finance goals in the decision to invest in an index fund. Take the time to solidify your investment goals before investing in index funds.

Factors to consider to determine the right index fund for you

As you explore your options, you’ll realize there is a wide range of index funds to choose from. With that, you might need some help to narrow down your options.

Personal investment goals

Even if you know how index funds work, that doesn’t mean that it is the best time for you to invest in index funds. The details of your personal financial situation will make a difference in determining which fund suits your goals.

Need some help creating an investment strategy? Take our free course to learn more about investing.

Investment minimum

Some index funds will require a minimum investment to get started. These minimum investments can range from a few hundred dollars to several thousand dollars. Depending on where you currently stand financially, a minimum investment could be a major hurdle.

If that is the case, then look for options with low or minimum investment requirements. Keep in mind that once you’ve crossed the minimum investment threshold, you can continue to add to your investment in smaller contributions.

Account minimum

Depending on what brokerage platform you are using, there may be an account minimum that is separate from the investment minimums. An account minimum is how much you need to have available in your account.

Some platforms have no account minimums, while others require fairly large minimums. Consider your ability to maintain your investments above the minimum account balance. Personally, I started out with a brokerage firm that didn’t have an account minimum.

Expense ratio

Although index funds generally have lower than the actively managed funds, there are still expenses to consider across index funds. You can determine how much fees will impact your long term return by comparing expense ratios.

Expense ratios are calculated based on a percentage of the value of your portfolio on an annual basis. You will find a range of expense ratios available. Some index funds even promise a 0% expense ratio. A small difference in this percentage can make a big difference in your long-term investment returns.

Should you start investing with index funds?

Index funds can be a good way to start investing. Once you’ve learned how index funds work, you can move forward with your investment goals more confidently.

However, consider your personal finances before moving forward. Remember that investing in index funds is a long-term strategy. With that, it is important to be prepared for unpredictable market cycles.

With that, you may want to reach other financial goals before jumping into index funds. For example, you might decide to prioritize building an emergency fund that can help you ride the market’s ups and downs more comfortably.

If you decide to move forward and invest in index funds, make sure to individually research any potential funds before sticking your money into a random fund. It is important to do your own research and understand exactly what you are investing in when you select a particular index fund.

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