How To Invest In Index Funds: The Best Tips

Last Updated: December 2, 2019
Advertiser Disclosure

Our content may include links to products from our partners

Index funds are simply mutual funds that track the returns of a market index.For the investor, making the indexing strategy is the easy part.  The harder part is deciding on the best portfolio mix .What is the difference between them various index funds and which of them fit for you?

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions .

In the world of investing, many accepted norms are being set aside in favor of new concepts and ideas.  One of them is the abandonment of the concept of investing based on performance.  Ironically, even the most experienced investors stand a very minute chance of beating the market.

With all the fees and costs that have sprung at every turn, it has become nearly impossible to succeed extraordinarily.  This could be our cue to shift from actively managed mutual funds to low-cost index funds and exchange-traded funds (ETFs).

The basic indexing strategy is very simple and remains the same throughout.  However, the investor may later experience a material change in his investment goals. In such case, he may change his indexing strategy midstream.

For the investor, making the indexing strategy is the easy part.  The harder part is deciding on the best portfolio mix. The investor must decide between stocks versus bonds and local versus international as an investment direction.

What Is an Index Fund

Index funds are simply mutual funds that track the returns of a market index.

An index is a compilation of securities that represents a specific fragment of the market.  The examples are the stock market, bond market, funds market and others. As an advantage, an index mutual fund provides:

  • Wider market exposure
  •  Low operating costs
  •  Minimal portfolio turnover

These funds follow more stringent standards or guidelines that stay in place no matter how the market behaves.  As a result, they manage taxes more efficiently and minimize tracking errors.

Among the popular firms that develop market indices are Standard & Poors and Dow Jones.

And remember:

As a rule, index funds will maintain all securities in the same proportion as their prevailing indices.  Companies organize index funds as a mutual fund, an exchange-traded fund, or a unit investment fund.  Some of the acknowledged companies that offer index funds are Vanguard, Fidelity and T. Rowe Price.

How to Get Started Investing

The list below enumerates the only index funds or ETFs you need to start achieving your goal.  Of course, you should choose ETFs or conventional funds that would suit your purpose. A mutual fund and an ETF that track the same index will basically perform the same.  That is, if their expenses are equal.

Here’s how it goes:

The market weighs the indices based on their holding’s market values.  This means that the more popular securities will get a heavier weight.  For each fund, we listed the symbol for the mutual fund first and then the ETF symbol.

If you are not an investing hobbyist and you don’t hire an adviser, an index fund is a way to go. This fund track broad market indices rather than try to beat them. The question is which one?

Interestingly, information is quite limited about building a diversified portfolio of good index funds. Investors will also have a hard time looking for materials to guide them how to adjust midway.  Standard & Poor’s 500 Index tracks the performance of large U.S. corporations but sadly, it is not a complete portfolio.

1. Vanguard Total Stock Market Index (symbols VTSAX, VTI)

This index can gets forty percent of your assets.

It will make the entire U.S. stock market available for you to just 0.05% per year.  You name it: small, mid-size or large companies – they can get it for you.  So, if you invest $100,000, you will only pay $50 to them for the expenses.  The fund will track the CRSP U.S. Total Market Index for you.  This means about 3,800 stocks, which is much larger than the S&P 500.

Nevertheless, stocks of large companies make up the majority of the index.  The fund’s annual returns remain close to that of S&P’s, varying only by one percentage point or so. In the last 10 years, the fund reported an earning of 8.6% (annualized).  This is higher by 0.6 percentage points per year than the S&P 500, on the average.

2. Vanguard High Dividend Yield (symbol VYM)

This income-focused index fund is more suited for investors who prefer dividend stocks. Blue chip stocks make up this fund. They may be slower to grow but they pay higher yields than the market average.  It lists more than 400 dividend stocks.  Its top holdings include Microsoft Corp. and Johnson & Johnson.  Both stocks pay over 3.5%.

For the twelve months ending August 31, 2017, the fund recorded an income return of 3.3%.  This is considerably higher than if the investor simply placed his money in a broad total stock market fund.  It also charges very low fees and reported an expense ratio of only 0.08%.

Take note that in opting for a higher cash return, you are trading some capital growth potential.  In fact, the prospectus cautions that the focus on higher yields should move the investment behind broader market indices.  This is more likely to happen during bull markets. Investors experienced this recently with the Vanguard High Dividend fund.  It’s total return for the prior year has been around 9 percentage points below the benchmark.

3. PowerShares QQQ (symbol: QQQ)

PowerShares QQQ is some sort of a leader in returns.  It is one of the best-established and most-traded ETFs in the world. QQQ tracks a modified market cap-weighted index of 100 NASDAQ-listed stocks. The fund only invests in nonfinancial stocks listed on NASDAQ and deliberately ignores other sectors.

In the past years, stocks intermingled across NASDAQ and New York Stock Exchange and made both indices more diverse.  Still, NASDAQ is upper heavy in technology companies.  This makes NASDAQ vulnerable to any trend or movement in the technology arena.  However, since technology, in general, has been on the upward trend up to this year, NASDAQ had been doing well.

The PowerShares QQQ tracks the NASDAQ quite well and reports a low 0.20% expense ratio. This is only a minimal portion of the overall return of the index.  QQQ has been trading very well on a daily basis.  Its high volume provides ample liquidity to the fund.  Investors can use this to avail of the NASDAQ tech stocks’ profit potential and increase their domestic stock exposure.

4. Vanguard Small-Cap Value Index (symbols: VBR)

You may try to put 10% of your investments into Vanguard Small-Cap Value Index.  It tracks the CRSP Small Cap Value Index.  This fund invests in many of the stock market’s smallest, cheapest and least popular companies. Technical stock analysts believe that these stocks will do better than their popular counterparts over the long haul.

Historical data supports this theory. However, you need to be patient here.  In the past 10 years, the fund registered an annualized return of 9.1% and expenses of 0.09%.

Index Funds Investment Tips

Choose a Leading Index Fund 

The market leaders are BlackRock, State Steel Global, and Vanguard.  They all meet the criteria.  The good news for index investors is:  the major providers’ low fees continue to go down even lower. But remember this trustworthy warning.  Fund managers that only tinker with indexing can charge high fees and expect investors not to notice.  So, buyers beware!

Use Your Stockbroker Account

If you have a stockbroker account, buying index funds is as easy as buying stocks.  Your stockbroker can do it for you. Of course, your broker might attempt to discourage you.  When you move into indexing, your stockbroker knows that there won’t be much trading.  Therefore, he tends to lose some commissions.

Consider Starting With ‘Plain Vanilla’ Index Funds

You may want to begin by investing in ‘plain vanilla’ index funds.  A plain vanilla fund is the most basic version of a financial instrument.  You can choose funds of large and mid-size company stocks like the S&P 500 or the FTSE Index.  You may also choose a total market fund that includes stocks of smaller companies.  Usually, these companies dominate most index funds.

Consider a Combination Of ‘Domestic’ And ‘International’ Index Funds

When we say ‘domestic’, it is helpful to note that these American companies earn the majority of their income in the international arena.  A good example would be Coca Cola. On the other hand, some global companies make their fortune in the United States.  A perfect example would be BP.

Half of the global stock market is ‘domestic’ and the other half is ‘international.”  If you want a simple diversification, you can go 50:50.  Since markets go up and down independently of each other, you may need to rebalance your portfolio annually.  If you use a global index fund, you don’t need to rebalance. Because it combines both U.S. and international markets, the fund basically balances itself.

 Set Your Own Ratio

You can limit your international funds to 10%, 20% or 30%.  The choice is yours.  Set a limit that you are comfortable with.

Think Long Term

One of the great benefits of indexing is that it implements your long-term investment policy decisions effectively. So, you should make sure you are willing to commit for a long-term, maybe about 10 years.  This requires a steady self-discipline.  But don’t worry though.  In case there is a good reason to modify your long-term plan, you can always change your holdings.

Mix

Make a decision as though you are still an active investor.

A good mix would be one high-grade bond index fund and one index equity fund. This will provide a broadly diversified, low-cost portfolio that will outperform most active funds.  This will have lower risks and lower taxes plus provide more confidence and comfort.  It will also take less time.

Move On

Later, you may see that some long-term prospects might be a more superior option.  They could be emerging market stocks or Japanese stocks or small capital stocks. In this case, you may want to ‘overweight’ – or go with highly recommended stocks that experts expect to be of better value.  Just make sure that you can stay with this for at least 10 years. Indexing works best when you sustain it for the long term.