Investing in index funds has long been considered one of the smartest investing moves you can make. Index funds are affordable, allow for diversification, and typically generate attractive returns over time. Historically, index funds have outperformed other types of funds actively managed by top investment firms.
Aindex fundsis a kindinvestment associationofexchange rate fund(ETF) - a bundle of securities that together track the performance of onemarket indexasS&P500(SNPINDEX:^GSPC). An index fund contains the same investments in approximately the same proportion as the index that the fund tracks. The index itself is usually focused on a particular sector, geography or stock market.
In 2007, Warren Buffett made a $1 million bet thatThe index fund would beat the returns of an actively managed hedge fund over ten years – and it won by a landslide.
Buffett's victory may be reason enough for some investors to add index funds to their portfolios. If you need more convincing, read on to understand what index funds are and why they are so popular.
Advantages of index funds
Index funds enable broad diversification, have low costs and offer attractive returns. Read more about these key benefits:
1. Bred diversification
The most obvious advantage of investing in index funds is that your portfolio is immediately availablediversified, minimizing the chance of you losing some or all of your money.
Consider an index fund that tracks the S&P 500. This index fund could hold approximately 500 different stocks. While the performance of each of these 500 stocks will fluctuate over time, investing in a fund that holds them all equates to the performance of your portfolio and that of the index itself. By spreading your portfolio across so many companies by investing money in just one index fund, you ensure that the value of your portfolio is not overly correlated with the fortunes of any company included in the index.
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2. Location costs
Another major benefit of investing in index funds is that costs, including taxes and management fees, can be lower than other types of mutual funds.
Low administration costs: The first costs to take into account are the management fees charged annually by each fund manager. The amount of compensation, which varies based on the value of your investments, is determined by the fund's expense ratio. For example, if you own $1,000 in a mutual fund with an expense ratio of 1%, you will pay $10 in management fees.
Actively managed mutual funds have expense ratios that are often between 1% and 2%. Most of this compensation is paid to portfolio managers to make buying and selling decisions in an attempt to outperform the overall market.
Index funds, on the other hand, dopassive board. Because they simply track an index by buying and holding all the stocks in that index, the index fund's investments rarely change. The expense ratio is relatively low because little work is required of the index fund manager.
Index funds typically have an expense ratio between 0.05% and 0.07%, and some index funds have an expense ratio as low as 0%. If you have $1,000 in an index fund with an expense ratio of 0.05%, you will only pay $0.50 in management fees.
Lower turnover ratio
The turnover ratio measures the percentage of a fund's investments that are turned over in one year. For example, if a fund invests in 100 stocks and 10 are swapped this year, the turnover ratio is 10%.
Index funds obviously have a lower turnover rate than actively managed funds. The turnover rate of index funds is usually around 1% to 2% per year, compared to 20% or higher for some actively managed mutual funds.
Lower tax on capital gains
If a fund sells a stock at a profit, the difference between the original purchase price and the final sale price is considered oneexchange rate gain. Funds with a higher turnover ratio are more likely to experience capital gains, resulting in more tax owed by investors in the fund.
However, this isn't as much of a problem with index funds, thanks to their low turnover ratios. Because fund managers don't sell shares all the time, there aren't often any capital gains to pass on to shareholders.
3. Attractive return
As Buffett knew when he gambled $1 million, even the smartest and most diligent portfolio managers can rarely manage actively managed funds to beat index funds. According to research from Standard & Poor's, only about 23% of actively managed mutual funds outperform the S&P 500 over a five-year period. Other studies also support this figure.
Individual companies both outperform and underperform the market, but overall the overall stock market increases in value over time. As a result, index funds generally offer high returns at low costs, making them excellent value for any investor.
How to start investing in index funds
You can buy index funds through areal estate agencyor an investment company such as Fidelity Investments or Vanguard. Your first step is to look at the index fund offerings and whether the funds have investment or account minimums.
If you don't plan to invest a lot of money initially, you should prioritize funds that don't have account minimums. Alternatively, you can get started with an ETF version of an index fund instead of a typical mutual fund, which will likely have a high minimum investment. The minimum purchase for an ETF is never more than one share.
Then select an index. S&P500 andDow Jones Industrial Average(DJIA) (DJINDICES:^DJI) are two of the best-known indexes for U.S. stocks, and index funds that track these indexes are a good choice for novice investors. But there are many more options. Take a look at how various index funds have performed historically. You should also check their expense ratios and compare them to other funds that track the same or similar indexes.
Whether you're new to investing or have experience, an index fund is a great asset to add to your portfolio. It takes some time to find the right index fund for you, but once you do, you can sit back and let your money grow.
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Adam Levyhas no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has onedisclosure policy.
