How much time are you willing to put into investing? Do you have any knowledge about investing? Do you have time to learn? If these questions make you uneasy then index funds might the best investment option for you.
With index funds, all you need is make some research at first and then you can start investing on autopilot.
Sounds too good to be true? Then keep reading and find out for yourself.
What is an Index Fund?
An index fund is considered an investment fund, a mutual fund of an exchange-traded fund (ETF). An index fund consists of a lot of stocks put together for you to buy.
These funds are not actively managed. So, the expenses are far less than the actively managed fund. This is great because a fund operates on a set of rules that actively managed fund does not follow. Because of that human emotion has very little impact on the decision of what should be put into these funds.
However, index funds do not stay the same. As some companies rise and some fall index fund changes their package as well. For example, the most popular index fund is the S&P 500 which consists of the 500 biggest US stocks.
If a company loses its position as a top 500 company it gets sold by S&P 500 index fund.
1. Why Index Funds are Popular?
Index funds are very popular because they consist of a lot of companies that provide lower risks. It does not require as much knowledge as investing in the stock market. So, beginners love these kinds of funds.
However, not only beginners should be interested in index funds. Even Warren Buffet said that most people should avoid stocks and invest in an index fund.
- Market average returns – over a long period of time only a handful of mutual funds that are actively managed perform better than index funds. However, many people try to beat the market. You can find a lot of books about people who tried and succeeded. On the other hand, there are at least 90% more people who performed a lot worse than the S&P 500 index fund over 20 year period.
- Diversification – investing in an index fund is like investing in 500 or more companies at the same time. For many investors, it is very hard to invest in 500 companies by themselves. Mostly because you need a lot of money to do it and you will pay a lot more taxes when you purchase and later sell that many companies. Index funds let you diversify a lot better.
- Low risk – because of diversification you instantly lower your risk to market fluctuations in different sections. You should know that the risk still exists and index funds have lost 50% of their value a few times over the last 100 years. However, it rose a lot more.
- Cheap entry – depending on the index fund and where you purchase index funds you can do it a lot more cheaply than investing in mutual funds. Index funds usually have less than 1% of fees. Not to mention that a lot of index fund shares that mimic the S&P 500 index fund right now cost around 400 USD.
- Tax efficient – index funds only required you to buy and hold them. When with stocks you always have to make new purchases and sell some positions when they are no longer attractive with their balance sheet.
- Passives investing – how much is there to do when you invest in index funds? After you have done your initial analysis and chosen where you want to invest there can be absolutely zero to do. You can even auto-invest each month if you want. So, you can avoid all the hassle.
2. The Smartest Investment Book You‘ll Ever Read
How many books have you read on investing in the stock market and beating it? I have read a few, and some of them are interesting, but have you ever read a book about investing in index funds?
The book ‘The Smartest Investment Book You‘ll Ever Read‘ by Daniel R. Solin does exactly that.
He has some interesting take on the kinds of investing and in a lot of cases I believe what he writes. He encourages you to diversify your index fund portfolio in 4 parts.
- Total Canadian stock index fund
- S&P 500 following index fund
- EFA index fund (Europe, Australia, Asia, and Far East total market)
- Total bond index fund
In what proportions you should own it depends on your risk level. To put it simply it depends on your age left till pension, your ability to increase your salary, and so on. The main thing that is different is that the less risk you are willing to take the more you should invest in bond index funds.
In this book, you can find a quiz that helps you determine what risk rating you apply according to your finances.
I did my personal analysis on these index funds and I believe they are very much diversified, however, the return is not that great. Only the US market‘s index funds can get you around 9% average annual growth.
Index funds from other countries do not perform that well and their average is half the US index funds. Moreover, bond index funds were doing terribly for the last 10 years. However, this might change when the crisis happens.
3. Types of Index Funds
There are a lot of different index funds out there and it can be hard to choose one or a few of them. I would classify them into 6 categories (at least the main ones) and then the choice is really yours depending on your location and current market situation.
The location is important because since 2017 European citizens cannot purchase US index funds directly because the US disagrees to provide required documentation about index funds that are not required in the US. You can read more about it on investopedia.com.
When I say that the market situation matters I mean that there are a lot of similar ETFs that follow the same indexes. You should choose the one that you trust the most, the one that has the most sales and purchases, and the one that has the lowest taxes.
S&P 500 Following Index Funds
There are a lot of index funds that follow the S&P 500 to choose from. For example, I purchased iShares Core S&P 500 ETF (IVV) (average annual return over 10 years is 12.53%) because it was the most traded index fund in Europe that tracks this index.
People in America have other good options like Vanguard S&P 500 ETF (VOO)
(average annual return over 10 years is 12.54%). I believe these are the ETFs that are essential in your portfolio.
These funds are considered safer than others since they represent the biggest US companies that have been around for a long time. This is what investors usually are looking for.
Total Stock Market Funds
If however, you want to earn exactly as much as the whole market performs you can choose total stock market funds like Vanguard Total Stock Market Index Admiral Shares (VTSAX) (Average annual return over 10 years is 11.66%) that tracks all the US market.
Another option would be Vanguard Total World Stock Index Fund (VT) (Average annual return over 10 years is 8.35%) which consists of pretty much every share from around the world. However, it gets you fewer returns.
These funds are good for you if you believe that smaller companies that are not on the top 500 list will do better. Thus your returns would be higher.
Small-cap Value Index Funds
These funds typically are traded at a low price compared to their performance. In a sense, they follow the value investing principles. Vanguard Small-Cap Value Index Fund (VSIAX) (Average annual return over 10 years is 9.89%) is one of them.
Another similar fund is Fidelity Small Cap Enhanced Index Fund (FCPEX) (Average annual return over 10 years is 10.91%).
Value index funds have less volatility but offer you fewer returns. So, you could consider them a safer investment.
Small-cap Growth Index Funds
Growth funds are best when the market is rising but a lot worse when the market dips. These funds have higher fluctuation so they are considered riskier. Vanguard Growth ETF (VUG) (Average annual return over 10 years is 12.92%) is one of the biggest growth funds.
iShares Russell 1000 Growth ETF (IVF) (Average annual return over 10 years is 13.9%) performed even better than the Vanguard fund.
These funds are built so they would do well in good times. The downside is that you have to get off the train early not to lose your money in the process.
International Stock Funds
International funds can provide you with more diversification from the US stock market. There are more risks with other markets as they are more volatile and it can be hard to predict returns of other countries as in general the whole market does not grow as fast as the US market but if you niche down to one region or one country that country start growing and give you better returns.
An example of an international fund can be Vanguard Developed Markets Index Fund Admiral Shares (VTMGX) (Average annual return over 10 years is 4.82%).
Fidelity International Index Fund (FSPSX) (Average annual return over 10 years is 4.82%) is another example.
You can find a lot of different index funds that have very different returns when you consider international index funds.
Bond Index Funds
When investing in these funds you are investing in US treasury bonds, agency bonds, corporate bonds, and so on. These index funds provide you with safe investments that are guaranteed by the US government. Volatility is quite low in these funds, however, returns are also not as high. These funds really shine in the market crashes providing you with returns when stocks tend to go down.
One of the examples is Fidelity U.S. Bond Index Fund (FXNAX) (Average annual return over 10 years is 0.99%).
Another example is Vanguard Total Bond Market Index Fund (VBTLX) (Average annual return over 10 years is 1.13%).
These funds really shine in the market crashes providing you with returns when stocks tend to go down. Since there was no real crash in the last 10 years returns were not great in this category.
4. How to Purchase Index Funds?
Once you know what types of index funds there are you should investigate them further and shorten your list. It might be a good idea to choose the best index funds from the 6 categories I have mentioned before and add them to your wishlist.
Before You Buy
- You should analyze what kind of expenses you will have to pay when buying, selling, and annually.
- Are there any particular risks with this fund?
- What index fund follows?
- Does the index fund‘s strategy hand in hand with my goals?
When you do your analysis and chose index funds you like you must pick the best place to purchase these funds.
Where To Buy?
• Your bank – My bank gives me quite good terms when buying index funds. For example, I pay 11 EUR for a purchase no matter how much I buy. This is quite good for me as there are no other expenses included and I do not have to make any additional transactions.
• Index fund company – A lot of index fund issuers sells their index funds themselves. However, if you choose to diversify between different companies it can be quite annoying for you to transfer your money. Also, some companies have minimum purchase limits that prevent new investors from making their first purchases.
• Broker – You can find yourself a broker that can do everything for you. However, keep in mind that he or she will probably charge you when doing a purchase or selling indexes. On the flip side usually, they can purchase every index fund no matter where you live.
• Third-party online brokerage company – There are some companies that act like a broker, however, they have their own website where you can do everything yourself. Of course, there are some costs included depending on the company.
I have tried interactivebrokers.com. They offer amazingly low investing fees compared to others. However, I found them hard to use and left a bad review when I couldn‘t buy S&P 500 and other US index funds. Only later I found out I could not buy them because I live in Europe (Sorry, interactivebrokers!).
This is an important step, do not skip it! Once you have your wishlist and you know where to buy index funds all there is left to do is figure out your diversification plan and prepare yourself for what you would do if the index fund would drop in value.
5. Why You Should Not Own Index Funds?
Although buying index funds is recommended by a lot of famous people like Warren Buffet right now might not be the best time to start investing.
- Highly affected by market fluctuations and crashes – the downside of index funds is that when the market goes down your investment takes a hit because index funds represent the market. When you pick your own stocks you can choose companies that should do well if the market crash happens.
- Not flexible – you will have to own even the stocks that you do not want to. Whereas with stocks you have full power to make these decisions for yourselves.
- No human interaction – index funds are preprogrammed. This means that even if you would have some information that one company is doing poorly and is likely to lose value the index would not do anything about it.
- Limited returns – You can only return what is the market average and you cannot outperform it. So your income is fixed on average 9% annual returns.
- The stock market is overvalued – In my previous article ‘Is The Stock Market Overvalued‘ I have proven that the stock market currently is overvalued with the help of some market indicators.
Conclusion
The advantages of investing in index funds are undeniable. However, like with every other investment, there are some risks that you need to evaluate. Here is a checklist if you want to start investing in index funds.
- Add 6 index funds to your wishlist from each category
- Choose the best place to buy them from
- Determine if it is a good time to buy them
- Decide on a diversification strategy
- Prepare what you would do if an index fund would lose its value
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