Index funds function like a slice of a particular index market by mirroring its composition and performance. This can be great for passive investors, but also comes with some caveats.
How to invest in index funds
If you’ve been following the gospel of investment diversification, then you’ve probably come across index funds. An index fund is a type of mutual fund (or an ETF) that’s meant to be a miniature copy of an established market index, such as the S&P 500 or the Dow Jones Industrial Average. This means that an index fund includes fractional shares of all components of a particular index and mirrors that market’s performance.
Index funds are popular among investors who take a more passive approach to investing and are more focused on a market’s long-term growth. And because an index fund gives you access to all the stocks within a single market, you’ve got diversification built right in. Here’s how to invest in them:
1. Know which market index you want to draw from.
Index funds mirror specific market indexes, so you have a number to choose from. Do you want to invest in an S&P 500 index, where you’ll have access to 500 companies across a wide range of industries? Or a Dow Jones index, which consists of stock from 30 large U.S. companies? Or maybe you want to go international, and look at the MSCI World Index, which covers 23 countries? Either way, you’ve got some options.
2.Decide how you’ll buy your funds.
Investing in index funds is pretty similar to investing in mutual funds or ETFs. You’re going to need to go through an investment platform or a brokerage, but there are a wide variety of options to choose from here. There are a huge number of investing platforms you can choose from online, depending on how involved you want to be in the whole process. With some platforms you determine when to buy and sell, whether you want to manage it yourself or have it managed for you, and at what frequency you’ll be investing. Also keep in mind that this means your fees will vary—more service equals more fees, naturally. (More on that in a minute.) Although index funds by their very nature tend to be managed less actively than, say, a portfolio consisting of individually selected stocks, you can get even more laid-back with the investing process by selecting a robo advisor, which is an automated investment service that will do the job of expensive wealth managers or investment advisors by using algorithms to create a portfolio based on your financial goals and your risk tolerance. It should be noted that robo advisors tend to invest your money in ETFs—some also invest in index funds.
The costs of investing in index funds will depend on what investment platform you choose. Some accounts will have pretty steep account minimums (the amount of money that has to be in your account at all times), while others might have higher investment minimums. Also keep an eye out for any commissions, transaction fees, and service fees. While investing in index funds is already quite a budget-friendly investing solution because of the relatively little management they require, automated investment platforms can sweeten the deal by doing away with managers and letting an algorithm do its thing.
Should I invest in index funds?
After spending a huge section of this article detailing how to invest in index funds, you’re probably wondering what the catch is. Index funds aren’t a great fit for every investor; it all depends on your personal goals, style, and comfort level.
One of the big pros of index funds: low costs. Because they mirror the market they’re picked from, index funds don’t require a super-involved manager who’s constantly trying to stay ahead of the market, selling and picking new stocks: the stocks have already been picked out for you by the market. There are also lower transaction costs, because you’re not picking, choosing, and trading individual stocks from within the market. Maintaining a portfolio of index funds will usually run you 0.05% to 0.25% annually, while actively managed funds can charge 1% to 2%.
Another benefit is the fact that index funds allow investors to participate in the long-term growth potential of a particular stock market, with a caveat: not all markets and not all index funds are created equal. It’s important, when researching what to invest in, to ensure that the market you’re investing in is a reliable one that has a history of long-term returns.
The key word here is long-term: since your investments will be mirroring an index, it’s natural that there will be ups and downs in the short-term. That’s why index funds are best suited for long-term financial goals, like retirement. Historically, big markets have provided steady returns for patient investors who don’t spend too much time fiddling about with their portfolio, and experts like ur-investor Warren Buffett himself have argued that index funds will usually outperform actively managed funds in the long run. The average annualized total return for the S&P 500 over the past 90 years has been 9.8%! Although past performance is no guarantee of future results.
So what’s the downside? Well, if you want to have control over your individuals holdings and invest more heavily in one sector of a market, such as technology, than in another then you’ll be frustrated with index funds, since they mirror the market as it stands. Index funds are set portfolios and you can’t really change their content, and for some investors, it’s important to have the freedom to act if they see a certain sector of the market being over- or undervalued.
Index funds tend to work best in the long-term. If you’re looking for quick returns after five years or so, your returns may not be able to keep up with inflation and you won’t be protected against any short-term market downturns. If you want to have access to interest-generating funds sooner rather than later, then a high-interest savings investment account might be better for you.
Some may say you could just buy index funds yourself rather than start investing with a robo-advisor. And you could buy index funds yourself. But then you wouldn’t be able to take advantage of dividend reinvesting, or have access to expert financial advice, or have your portfolio balanced by experts when it becomes prudent to do so. For many, the service a robo-advisor provides are worth the little extra fees you have to pay.
How many index funds should I invest in
The truth is that because an index fund covers an entire market, you only really need to invest in one to be “diversified.” As long as that market itself is diversified enough, like the S&P 500, your fund will be diversified too.
Of course, you can always enhance your assets with the help of a robo-advisor, which can help spread your money across more sectors with the help of ETFs, which can cover stocks, bonds, real estate, and international markets. That way, you’re not just stuck in one market and can diversify even further.
Keen to talk more about diversification? At Wealthsimple we’ll help take the guesswork out of investing by working with you to create a balanced, diversified portfolio of ETFs calibrated to your risk level and financial goals. Sign up today.