Question: I've read that index funds are the smartest choice for someone like me who's interested in low-cost investing over the long term. But there are so many to choose from! How do I go about picking a fund that will be worth holding onto for years? -- Helen, New Orleans
Answer: Great question, Helen. I personally love investing in index funds. They're an excellent diversified investment for 401k plans, IRAs and other retirement plans as well as taxable investment accounts -- especially if you don't want to have to spend hours researching your mutual fund performance every quarter.
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks a market index and mirrors the performance of that index.
One of the most popular indexes that people follow, for instance, is the S&P 500 index, which follows the 500 largest companies in America (Think Apple, Exxon, Microsoft, Walmart, etc).
Naturally, there are index funds that you can invest in that will follow the performance of the S&P 500 index (or almost any index on the market), which we'll talk about next.
How does an Index fund work?
By investing in shares of an index fund that tracks the S&P 500 stocks, I can automatically be invested in all 500 US companies that make up that index.
For example, if I buy shares in the Vanguard 500 Index Fund (Nasdaq: VFINX), which tracks the S&P 500 Index, and the S&P 500 goes up 10%, the Vanguard fund will go up almost 10% as well.
I say 'almost' because the expense fees, which come along with all mutual funds, will take some of the returns. As most index funds do, the Vanguard 500 Index Fund carries a very low annual expense ratio -- 0.14% in this case. So if the S&P 500 went up 10% over the year, my investment would go up 9.86% in this example.
Because index funds track market indexes, they don't have portfolio managers actively buying and selling investments within the funds as regular mutual funds do. And with less activity from the portfolio manager, index funds often carry much lower expense fees and are potentially less risky than normal mutual funds with managers who try timing the market.
That also means that you, the investor, don't need to carefully compare the performance of the fund to the market index's performance because with an index fund, you're essentially investing in the market you're comparing against.
In short, index funds are a low-cost, hassle-free way to diversify into several different investment types at once -- and for the long-haul.
How to be Fully Diversified with Index Funds
Before we dive into the various types of index funds, let's talk big picture -- your investment mix.
Remember, everyone's investment portfolio is different. Yours should be made up of different investment types that fit your age and risk tolerance, so do your research on portfolio allocation or talk to a trusted advisor for more help on that.
For our purposes, I'll keep this basic. As I talked about in The Lazy Man's Retirement Portfolio, there are basically four major asset classes in which to invest: U.S. stocks, foreign stocks, real estate and bonds.
You can also invest in commodity index funds, but they're a bit outside of the normal asset classes so we'll skip that one for today.
For each of the asset classes you want to invest in, you'll want an index fund that tracks it.
If you want exposure to American companies, you may want to invest in a stock index fund that tracks the Wilshire 5000 index, which includes virtually every small-, medium- and large-cap stock traded in the United States -- more than 5,000 companies in all. An example of an index fund that does this is the Vanguard Total Stock Market Index Fund (Nasdaq: VTSMX).
If you're looking to invest only in large, established companies (Wal-Mart, Exxon, Apple, etc.), you may prefer to go with an index fund that tracks the S&P 500 Index (like the one I mentioned earlier, for example), which tracks the 500 largest companies in the United States.
For exposure to companies in countries with explosive economic growth, foreign stock index funds are just the ticket. There are plenty of emerging countries index funds to choose from that invest in companies in Mexico, China, Brazil and others, as well as developed countries index funds, which invest in companies in Europe, Japan, Canada and others.
If you want exposure to both emerging and developed countries, choose an index fund that tracks the MSCI EAFE index, which follows companies in Europe, Australia and the Far East. An example of an index fund that does this is the Vanguard Total International Stock Index Fund Investor (Nasdaq: VGTSX).
If you want to own a part of apartment complexes, retirement homes and other kinds of properties, real estate investment trusts (REITS) are the easiest way to do it without having to buy land. To get this kind of exposure, you'll want an index fund that follows the MSCI US REIT Index, which represents 85% of the REITs in America. An example of a REIT index fund that does this is the Vanguard REIT Index Fund (Nasdaq: VGSIX).
Finally, if you want some of your investment dollars to be in a diverse group of bonds, you'll want an index fund that tracks the Barclays Capital Aggregate Bond Index.
That index represents most investment-grade bonds traded in the United States: treasury securities, government bonds, mortgage-backed bonds, corporate bonds and even some foreign bonds. An example of a bond index fund that does this is the Vanguard Total Bond Market Index Fund (Nasdaq: VBMFX).
How to Buy Low Cost Index Funds
Several brokers, including Vanguard, Charles Schwab, Fidelity and others offer index funds, all of which are very similar except for one thing -- expense fees.
You'll want to look for index funds with the lowest expense ratios, which you can find on every mutual fund's prospectus page or on Morningstar.com). That can help you keep your costs down and your returns growing as much as possible. Typically, an index fund with an annual expense ratio that's 0.6% or less is decent, but an expense ratio under 0.15% is ideal.
You'll notice I mentioned Vanguard index funds throughout this article because Vanguard is usually the low-cost leader in the fund space. That said, it's still worth it to shop brokerages for the lowest costs.
How to Start Investing in Index Funds
In summary, there are three steps to get started: Determine which asset classes you'd like to invest in for diversification, find a brokerage firm that offers low-cost index funds that track those asset classes, then just set and forget.
Index fund investing is as simple as that.