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.
Table of Contents
- What Are Index Funds?
- How Do Index Funds Work?
- How Do I Invest in Index Funds?
- Why Can’t I Just Invest In the Underlying Assets Myself?
- Advantages of an Index Fund
- Disadvantages of an Index Fund
- Why Would an S&P 500 Index Fund Ever Rebalance?
- ETFs vs. Mutual Funds: Which Are Better?
What Are 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.”
How Do Index Funds Work?
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.)
How Do I Invest in Index Funds?
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:
- Choose the index in which you’d like to invest. Clark prefers to invest in a broad swath of large, successful companies. But index funds come in different flavors based on asset types (stocks, bonds, commodities, etc.), size (small-, mid- and large-cap companies), industry (tech, airlines, etc.) and more.
- Decide which version of the index to invest in: the ETF or the mutual fund. Typically, funds tracking specific indexes come in both types. If you’re in a taxable account, the ETF version is preferable due to the tax implications.
- For mutual funds, pick the company through which you’d like to invest. Clark recommends Vanguard, Fidelity and Schwab for most every investment choice, including index funds. Things to consider include cost (expense and tax-cost ratio), minimum investment size, commissions on trades and convenience (it may be nice to handle all your investing needs through one company).
- Select and invest in the individual fund. At this point, you know the index fund you want. If you want it as an ETF you can buy on the open market. If you want it as a mutual fund you can buy through a specific company. Buying works much the same as making a purchase on Amazon or through any other online vendor. All investment companies, even legacy companies, offer the ability to invest online without assistance from a broker.
The Clark-Recommended Index Funds
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.
|10-Year Annual Return
|Fidelity Total Market Index Fund
|Fidelity 500 Index Fund
|Fidelity Zero Total Market Index Fund
|Schwab S&P 500 Index Fund
|Schwab Total Stock Market Index Fund
|Vanguard 500 Index Admiral Shares
|Vanguard Total Stock Market Admiral Shares
*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.
Why Can’t I Just Invest in the Underlying Assets Myself?
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.
Advantages of an Index Fund
Here are some of the biggest benefits that index funds provide:
- Diversification. Whether you invest $1 or $10 million, you’ll get a diversified portfolio that can help lower your risk and increase your long-term return.
- Inexpensive. They’re more affordable than actively-managed mutual funds or ETFs. They charge less in annual fees and also create less of a tax burden.
- Saves time. Allowing an index fund to invest in the underlying assets and rebalance when needed saves your time — potentially in huge quantities.
- No need to pick stocks. As Clark points out, when you invest in an index, you’re betting on the entire index to perform well rather than on one particular asset. For example, a total stock market index fund gives you exposure to American capitalism as a whole, which historically has been much more stable than any one company.
Disadvantages of an Index Fund
Here are some of the downsides of investing in an index fund:
- Capped performance. If you’ve ever taken an informal opinion poll, you probably understand the idea of variance. Ask one friend with eclectic taste to name their favorite ice cream and the answer may be burned popcorn. Ask 10,000 people, and you’re more likely to get a representative sample (a lot more vanillas). The same is true when it comes to investing. Putting all your eggs in one basket generates a lot more variance than diversifying. The benefit of diversification is lower risk. The downside is that you’re not going to generate an unusual, outsized return.
- Inflexible. Index funds managers don’t get to choose what to include in their portfolios. They invest in the underlying assets in the index they’re supposed to track, for better or worse.
- Can own stocks you don’t want. Socially responsible investing (SRI) has become more popular in recent years. If you care about investing only in companies that make a positive social impact (whether that’s on the environment, gender equality or anything else), index funds can be tricky.
Why Would an S&P 500 Index Fund Ever Rebalance?
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:
- Inflows and outflows. In a big index fund, a large number of people buy and sell fund shares every day. If, on a particular day, more money is going out to sellers rather than coming in from buyers (or vice versa), the fund may need to sell some of its holdings or invest more money. The fund manager has to execute those transactions in a way that maintains the correct portfolio allocation relative to the index.
- Changes to the index. The S&P 500 is based mostly on market capitalization. The stock price of a company not in the index can rise and the price of a company in the index can fall. Therefore, the companies that are part of the index can change. When that happens, the fund manager needs to sell off the stock no longer in the index and buy the stock of the company moving into the index.
- Company decisions. Businesses within the S&P 500 can conduct stock buybacks or make secondary offerings to raise more capital. That can create a need for a fund manager to rebalance.
ETFs vs. Mutual Funds: Which Are Better?
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.