Investing in Index Funds: Everything You Need to Know

Investing in index funds is a low-cost, low-effort way to profit from the value added by every publicly traded company in corporate America and beyond.

As a certified professional market analyst, investor, and trader for over two decades, I can tell you I have over 80% of my stock portfolio invested in index funds. Stock trading is for short-term high-risk gains, investing in long-term index ETF strategies is for a happy and comfortable retirement. Read on to learn how to make money in index funds and sleep well at night.

Investing in Index Funds
Investing in Index Funds

What is an index fund?

An index fund is an exchange-traded fund (ETF) or a mutual fund that seeks to match the performance of a benchmark index like the S&P 500, or the Nasdaq 100. The index fund achieves parity with an index by ensuring it owns a representative sample of all the equities in the index.

Buying a share of an index fund means you buy a portion of all of the stocks in the underlying index being tracked by the fund.

The basis of an index fund is an index. An index is a portfolio or list of equities, commodities, or securities, usually stocks. An index fund is an investment fund that only owns equities, securities, or commodities on a specific index. For example, an S&P 500 index fund only invests in stocks on the Standard & Poor’s 500.

Index ETFs vs. mutual funds

ETFs hold many advantages over mutual funds when investing in an index, such as tax efficiency, lower costs, and better liquidity. ETFs are traded openly on an exchange, are passively managed, meaning they cost less and are tax-efficient by allowing investors to trade directly with each other, thus avoiding redemption and therefore capital gains tax.

When deciding on an Index Fund, you need to consider the type of fund, a mutual fund or an exchange-traded fund. Exchange-traded funds are growing wildly in popularity due to their structure and benefits.

ETFs vs. Mutual Funds ETFs Mutual Fund
Index Funds
Actively Managed
Passively Managed
Fees 0% – 0-6% 1% – 3%
Traded Like Stocks on Exchanges
Can be traded: Intraday End of day
Tax Advantages

Table: ETFs vs. Mutual Funds Comparison

For independent investors seeking to maximize compounding by keeping costs low, seeking to pay less tax on gains, and wanting to be able to sell their investments whenever they want without penalties, index ETFs are clearly the better option.

Key Takeaways

Mutual funds are generally actively managed by teams dedicated to beating the market, but only 17% succeed in their goal.

Passively managed ETFs track a specific stock market index to at least equal the market returns; this beats 82.5% of mutual funds in the long term.

Passively managed index-tracking ETFs usually incur much lower management fees than actively managed mutual funds. A fee saving of 2% per year compounded for 20 years could mean an extra 48% extra in your investment.

ETFs are exchange-traded funds, meaning they can be purchased on the open market during trading hours and typically reflect the stock index price. ETFs can also be shorted and allow options trades.

Mutual Funds & ETFs are index Funds

Whether you decide to use a mutual fund or an ETF, you can still invest in an index. The difference is the process in which you invest your capital. A mutual fund index investment flows through a financial advisor or your retirement fund, and an index ETF investment flows from you straight to the stock exchange.

Using Mutual Funds or ETFs to invest in index funds - Process Flow
Using Mutual Funds or ETFs to invest in index funds – Process Flow

Why index ETFs are better than mutual funds

An index tracking ETF trades like a stock on an exchange and attempts to mimic the movement of a particular stock index such as the S&P500 as closely as possible while keeping fees to an absolute minimum. Low management fees and performance close to that of the underlying index are the hallmarks of an index fund.

Why invest in index funds?

There are four important benefits when investing in index funds, diversification, steady inflation-beating returns, little research is required, and buying an index ETF is as simple as buying a stock.

Index fund diversification

Index funds are naturally more diversified than investing in an individual stock or commodity. An index consists of at least 100 stocks for the Nasdaq 100, 500 stocks for the S&P 500, or even 3,000 stocks for the Russell 3,000.

For example, owning an individual stock could mean that you experience regular price fluctuations of 5 or 10% in one trading day, whereas owning an index such and the S&P 500 means you may experience a price fluctuation of 5% only once every five years.

Indexing is a risk management tool that reduces risks through diversification. Diversification means buying many investments to reduce risks.

The theory behind diversification is that you can lose all your money if you concentrate your investment in one sector. For example, a tech sector crash could wipe out a person who only owns a few technology stocks.

Diversification tries to protect a nest egg by putting money into different sectors or investments. The theory is that you are less likely to lose your money if you diversify your investments. Experts recommend diversification for people saving for retirement.

Advocates believe the more diversification, the higher the margin of safety. Indexing is an effort to achieve a high level of diversification. An S&P 500 Index Fund includes 500 stocks in many industries and is one of the most diversified investments available.

People who purchase index funds are buying a diversification strategy. They design funds such as the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) to offer a high margin of safety. The hope is that SPY will retain value because it holds equity in the 500 most successful companies in the USA.

They base the diversification of Index Funds on Modern Portfolio Theory. Economist Harry Markowitz created Modern Portfolio Theory in the 1952 Journal of Finance paper Portfolio Selection. The theory was so influential that Markowitz won a Nobel Prize in economics.

Modern Portfolio Theory teaches that the right mix of investments can offer higher returns and lower risks. When fund managers create an index, they apply Modern Portfolio Theory.

Steady Inflation Beating Returns

Index funds are popular because they offer high rates of return on a steady basis. The S&P 500 offered an 18.4% annual rate of return in 2020, and a 31.49% annual rate of return in 2019, according to Stock Rover. The S&P 500 offered an average long-term return of 9.64% in the period ending on February 1, 2021.

One belief behind indexed funds is that the regular high rate of return will cancel out losses. The S&P 500’s 31.49% return in 2019 and 21.83% return in 2017 made up for the -4.38% loss in 2018, for example.

Many investors believe that high returns and steady growth reduce risk. The constant growth offsets losses in declining industries and reduces the risks from economic downturns and market losses.

An S&P 500 index fund, such as the SPY or the Vanguard S&P 500, will hold stock in technology companies such as Apple (AAPL) and rising businesses like Tesla (TSLA). The S&P 500 investor theoretically enjoys the benefits of technology stocks without the risks.

Little Work or Research is Necessary

One reason for the popularity of index funds is that investing in them often requires little work or research. Index fund investors do not have to spend hours researching individual stocks or companies. No knowledge of the markets, the economy, technology, products, or politics is necessary. All the investors need to do is put money in the fund.

When you own an S&P Index Fund, you do not have to follow the market daily or individual stocks. The fund will buy stocks based on their market caps.

Index funds are popular with investors who do not have time for research. Professionals with full-time jobs and families like index funds because they make investing fast and simple.

Many advisors recommend index funds because they require little investor education. The advisor does not need to spend hours explaining an investment or the markets to a person who dislikes talking about financial matters.  Index funds are popular because they require little thought, work, time, or research.

Investing in Index Funds is Easy

Index funds are popular because they are simple and easy to invest in. You can buy fractional shares of index exchange-traded funds (ETFs) through apps such as Robinhood, the Cash App, Interactive Brokers, Gemini, and WeBull for as little as 1¢.

A fractional share is a tiny percentage of a stock or ETF. For example, you could buy $5 worth of the SPDR S&P 500 ETF Trust (NYSEARCA: SPY). People who cannot afford to pay several hundred dollars for a SPY share can invest in SPY with fractional shares.

Anybody can purchase index mutual funds from companies such as Vanguard and Fidelity. You can begin the purchase process by going to the company’s websites.

Many organizations allow employees to purchase mutual funds and ETFs through 401k and other investment plans. The advantage of these tax-deferred investments is that they take the funds from your salary. Many organizations’ human resources departments make it easy to enroll in 401k plans.

Why should you avoid index funds?

Index funds have drawbacks that make them poor investments for some. The investment media, financial advisors, and fund companies often hide these drawbacks to make index funds more appealing. All investors need to understand index funds’ limitations.

Individual stocks can grow faster than indexes.

According to Stock Rover, the 5-year return of Amazon.com is 325% versus the S&P 500 return of 112%. Individual stocks could better serve people who want high growth rates and investments they can sell for cash. Individual stocks can offer higher rates of growth and return. Stocks are also better for speculation. The tough challenge is picking the right growth stocks that will beat the market in the future.

The risks from individual stocks are far greater than those from index funds. Diversification reduces risk, but it often leads to lower overall returns.

Everybody who buys an index fund must realize that they are forgoing other opportunities that could be far more profitable but that those opportunities will carry far higher levels of risk.

There is no guarantee of index growth and returns.

The great attraction of indexes is the long-term margin of safety and steady growth that indexes offer. Index funds can suffer enormous short-term losses, however.

The S&P 500 lost 38.49% of its value during the financial crisis crash of 2008, but in 2009 it recovered from that loss when it grew by 23.45%.

The S&P 500 can suffer multi-year losses during a stock market crash. According to Stock Rover, the S&P 500 shrank in 2000, 2001, and 2002 and fell by 10.14% in 2000, 12.04% in 2001, and 23.37% in 2001.

History shows that steady index growth is not guaranteed every year. There have been periods of losses. Index recovery can come fast; Stock Rover estimates the S&P 500 grew by 26.38% in 2003.

Investors need a system to help them avoid stock market crashes when investing in index funds.

Index investors have no control over the fund holdings

Many people love index funds because they do not have to research or pick stocks. This lack of control can create moral and other hazards for investors.

An index fund could hold stocks in companies in which investors have moral or philosophical objections. An S&P 500 fund could own tobacco companies, gambling companies, distillers, brewers, companies that distribute offensive entertainment programs, oil companies, defense contractors, and companies that build weapons. An index could also hold stock in companies that engage in union-busting and outsourcing or companies that donate money to politicians people object to. Many large American companies donate to politicians and organizations, such as the Republican and Democratic parties.

A new type of index fund is emerging based on Environmental, Social, and Governance (ESG). ESG indexes refuse to invest in oil companies, for example. There are also indexes based on Christian and other religious values. They design some indexes to fit moral criteria.

The proposed Alpha Architect ETF Trust will only hold stock in companies run by what its creators call “high-character” CEOs, a Securities & Exchange Commission (SEC) filing claims. The high character could mean CEOs with high ethical standards or exemplary behavior.

You will be stuck with the index’s strategy.

Managers design index funds to implement a strategy automatically, an S&P 500 Fund will sell any stock that leaves the Standard & Poor’s 500, no matter how good that stock is.

Research Affiliates analysts allege Apartment Investment and Management (AIV) outperformed Tesla (TSLA) in July 2021, Yahoo! News reports. Tesla Motors replaced Apartment Investment and Management on the S&P 500 in December 2020.

Most S&P 500 fund owners invest in risky stocks they would normally avoid because those stocks are in the index. They base the S&P 500 Index only on the market capitalization of companies. Nobody evaluates S&P 500 stocks for their performance.

Index fund investors need to be comfortable with the index’s strategy because they are stuck with that strategy.

How do index funds work?

Index funds work by replicating the price movement of the benchmark index. When an investor purchases shares in an index tracking ETF the fund must purchase the equivalent amount of all stocks in the index to ensure the total value of its assets is has parity with the index.

This process is automated for passive index-tracking ETFs; machines buy and sell the equivalent investments in the index, typically achieving 99% parity with the benchmark index.

What are low-cost index funds?

A low-cost index fund is typically an index-tracking fund like the SPDR S&P 500 ETF Trust (Ticker: SPY), a passive fund that replicates the performance of the S&P 500 but charges less than 0.2% per year in management fees.

The equivalent actively managed S&P 500 mutual fund could charge up to 3% per year in fees.

What is the best index fund?

While there is no “best index fund,” well-managed funds have low costs and are large enough to guarantee longevity. The best index funds have over $1 billion in assets under management, expense ratios under 0.2%, and are with 1% of the performance of the underlying benchmark index.

What are the best index funds to invest in?

Here is a list of the ten best index funds ranked by most assets under management (AUM) and lowest expense ratios.

Ticker Best Index ETF Net Assets ($M USD) Expense Ratio
VTI Vanguard Total Stock Market Index Fund ETF Shares $1,313,470 0.03%
VOO Vanguard S&P 500 ETF $821,279 0.03%
SPY SPDR S&P 500 ETF Trust $411,595 0.09%
IVV iShares Core S&P 500 ETF $315,126 0.03%
VIG Vanguard Dividend Appreciation Index Fund ETF Shares $77,169 0.06%
ITOT iShares Core S&P Total U.S. Stock Market ETF $43,986 0.03%
VV Vanguard Large-Cap Index Fund ETF Shares $40,770 0.04%
SCHX Schwab U.S. Large-Cap ETF $33,717 0.03%
IWB iShares Russell 1000 ETF $30,267 0.15%
USMV iShares MSCI USA Min Vol Factor ETF $30,049 0.15%

Table: Best Index ETF Funds Jan 2022

The best index funds to invest in long-term?

The best index funds to invest in track the highest-performing indices. The three best performing indices over the past 10-years are the Nasdaq 100 +610%, the Nasdaq Composite +490%, and the S&P 500 +272%.

Source: TradingView

The best index funds to invest in long-term. Top Performing Stock Index Funds: 10-Year Chart to 2022.
The best index funds to invest in long-term. Top Performing Stock Index Funds: 10-Year Chart to 2022.

What happens to index funds when the market crashes?

Over the last 100 years, there have been six major stock market crashes, with an average loss of 57%. If the stock index drops 57%, you can expect the index fund to lose approximately 57%. In the 2020 Covid crash, the S&P 500 lost 38% of its value in 4 weeks, and so did the SPDR S&P 500 index-tracking fund.

How to prepare for a stock crash if investing in index funds?

To prepare for a stock crash while owning index funds, you have two options; firstly, you need to own a large, highly liquid index-tracking ETF that can be quickly sold on the open market. Secondly, you could decide not to sell but employ dollar-cost averaging to buy more positions as the stock prices decrease.

Selling your index fund during a crash is known as market timing. No one really knows the duration of a stock market crash or how much the market will decline. You could sell at the bottom of the crash and miss out on the market recovery.

Using dollar-cost averaging, you could decide not to sell during a crash but accumulate more stock for lower prices as the market declines. This strategy requires you to have sufficient funds in cash and have the time to let the market recover.

A strategy for beating the market with index funds.

One of the best strategies to invest in index funds and outperform the market is to avoid major stock market crashes. To avoid crashes requires you to be a master of technical analysis and have a rigorous backtested system that has worked on all previous stock market crashes.

I have developed an ETF index investing system that beats the underlying benchmark index and lowers your risk at the same time. I achieve this by avoiding major stock market crashes.


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