Index funds are among the most popular retirement investments. But exactly what are they, and what are the best index funds?
In this article, I’ll explain why index funds are such strong long-term investments and how to invest in index funds.
An index fund is an investment portfolio that mimics a financial index.
In the investing world, an index is a way to track a broad swath of assets. Most commonly, those assets are stocks or bonds. For example, the Standard and Poor’s 500, better known as the S&P 500, tracks the combined stock price of the 500 biggest public companies in the United States.
When you put your money in a fund, you’re allowing the manager of that fund to invest it. In the case of an index fund, the fund manager tracks the underlying index as closely as possible. So an index fund that focuses on the S&P 500 should own stock in each of the 500 companies.
Index funds can lower your risk and improve your long-term return on investment (ROI) by offering you inexpensive, diversified portfolios — saving you a lot of time in the process.
“Remember that the goal should be financial security for your life. And you do that not by betting the farm on one company,” Clark says. “I want you betting on the future of capitalism, not the future of a single company.”
Index funds can be mutual funds or exchange-traded funds (ETFs).
In either case, the overriding characteristics are the same. Index funds are passively managed. Rather than trying to beat the market by buying and selling the right asset for the right price at the right time, index funds track their underlying indexes.
Some level of buying and selling takes place even in a passively-managed fund. That’s inconsequential if you invest in an index fund through a tax-advantaged retirement account such as a 401(k) or Individual Retirement Account (IRA). But if you buy shares of a mutual fund in a taxable investment account, you’ll probably owe taxes even if you don’t sell any of your shares. (More on that later.)
Investing in index funds is not much different from investing in a stock, which is to say it’s pretty simple.
If you have a 401(k) plan, you almost certainly have access to investing in index funds. If not, you can still invest in index funds through an IRA or even through a taxable investment account.
Here are the steps you’ll take:
Clark recommends target date funds as the most appropriate investment choice for almost everyone. But he also says that if you want something more exciting, you can invest in a total stock market, international and bond fund.
Bond funds in particular come with a variety of options at each of Clark’s favorite investing companies. So let’s look at the total stock market fund (one of his recommendations) and S&P 500 index funds (which I’ve talked about a lot in this article) at Fidelity, Schwab and Vanguard, three of Clark’s favorite investment companies.
*Fund inception: Aug. 2, 2018
Vanguard’s index funds are notoriously inexpensive. The two Vanguard funds in this chart charge four pennies on every $100 you invest. Schwab charges two or three cents on every $100. Fidelity charges even less.
It’s even possible to invest in Fidelity index funds for free via the Fidelity Zero funds, which don’t charge any expenses.
You can also tell from the chart that you can have funds tracking the same index — the total stock market or the S&P 500 — that don’t end up with precisely matching annual returns. Fund managers make bigger impacts in actively-managed funds. Combined with the expense ratio, the impact of each company’s index fund choices is small but they add up over time.
The S&P 500 isn’t the only index fund. But it makes for a good example.
Investing in all 500 of the companies in the S&P 500 used to be prohibitively expensive. With fractional shares and commission-free trades now commonplace, these days you can invest as little as $500 and own $1 in all 500 companies.
However, owning individual index components can be clunky.
To make this illustration simple, let’s pretend that our index contains stocks from only two companies. Company A trades at $100 per share and Company B trades at $1 per share. If you invest $1 in both, you’ll own 0.01% of a share of Company A and 1 share of Company B. Company B makes up less than 1% of the combined index but 50% of your investment.
Although there are “equal weight” funds that invest an equal percentage of the portfolio into every stock inside the index, that’s not the idea behind typical index funds. Sometimes the biggest companies are the ones that perform best. Limiting those companies to a smaller share of your portfolio could negatively impact your ROI.
In almost every index, Company A isn’t going to account for 99% of the value. Instead of investing an equal amount, let’s say that you simply buy one share of each stock in an index. What happens if you have extra money to invest but not enough to buy an additional one share of each company in the index? And what if instead of 500 companies in the index, there are 10,000?
You could potentially divide the pool of money you have to invest and buy fractional shares. But if you’re investing new money regularly, such as a portion of each paycheck, you’ll have to repeat that process often. Like I said, clunky.
It’s much easier to let an index fund do all that work for you at a low cost.
Here are some of the biggest benefits that index funds provide:
Here are some of the downsides of investing in an index fund:
Why would a fund manager ever need to rebalance an S&P 500 index fund? And why should you care? (Hint: a word that begins with a “t” and ends in “axes.”)
If you invest in an S&P 500 index fund, the underlying assets are – drumroll, please – the 500 companies in the S&P 500. The stocks in that portfolio are pre-determined.
So why would a fund manager ever buy and sell? Selling an asset that’s worth more than when you bought it grabs the attention of the IRS, assuming you’re investing outside of a retirement account.
Here are some of the reasons:
An index fund can be an ETF or a mutual fund, which are similar investment types.
ETFs trade on the open market like stocks. You can buy and sell shares when the market is open. As a result, ETFs are more liquid, than mutual funds, which you can only buy through pre-orders at the end of each business day for whatever the price happens to be.
If you’re investing outside of a retirement account, ETFs are preferable. Mutual funds conduct more internal trading, which leads to a higher capital gains tax bill for you as an investor. Again, that matters only if you’re investing outside of a 401(k) or IRA.
Since ETFs trade on the open market, investors have to contend with what’s known as the bid/ask spread. A bid is the maximum price a buyer is willing to pay, while an ask is the minimum price a seller is willing to accept.
Index funds are based on underlying assets. Sometimes the ask is a little more expensive than the price of the underlying securities. There are computers that control the supply of ETFs to make sure the price closely matches the index, but it can vary slightly.
Mutual funds tend to charge more expensive ratios than ETFs due to marketing and operational costs. But in the form of a passive index fund, both are relatively inexpensive. (Not all mutual funds and ETFs are index funds. They can be actively managed as well.)
Index funds may not seem sexy. But when it comes to investing, a total stock market index fund is one of the best long-term choices you can make.
Investing in the right index funds are ideal ways to fund your retirement. If you make sensible choices (ETF vs. mutual fund, which company’s fund to invest in, which index to invest in), it’s also a Clark-approved way to invest for retirement.
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