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In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
I think this is a good trend, as I practically beg new investors to keep it simple.
The easiest way to keep it simple is by not investing in individual stocks. There are also way too many investors getting ripped off by the high fees that come with actively managed funds, a majority of which do not outperform a passive index over the long-term.
To new investors this jargon can be confusing.
I was telling a friend recently about index funds, and I got a blank stare. He jokingly said, “index cards? Is that what you are talking about?”
Investing can be intimidating because of how some people over-complicate it. If you watch “Made Money” you would think stock picking is something everyone should be doing. In reality, most investors – and certainly new investors – would benefit from focusing on low-cost index funds that track the broad stock market.
Let’s start by answering the question: what is an index fund?
Index Funds Explained
Index funds are mutual funds or Exchange-Traded Funds (ETFs) set up to track the performance of a benchmark index, such as the S&P 500. Said differently, they move up or down in price based on a large basket of stocks. This is beneficial because you spread your exposure across many companies. Compare that to investing in only a handful of individual companies. If one of those companies failed and went bankrupt, a large portion of your investment portfolio would be wiped out. With an index fund exposure is spread out across many, many companies, reducing your exposure and risk related to any one company.
Many index funds are capitalization weighted, or cap-weighted, which means that the larger components are given a larger weighting. For example, if you look at the Fidelity total stock market index fund you will see that the top holdings are, among other large companies, Microsoft, Apple, Amazon, and Facebook. The reason they make up a higher percentage than say, a small company whose market capitalization is only $10 million, is because having the same exposure to Apple as a $10 million company would give too much exposure to the small company.
Index funds are passively managed, meaning there is not a fund manager trying to “beat the market.” This allows the funds to have low fees, sometimes as low as 0.00% (for example, Fidelity’s total stock market index fund FZROX). The problem with actively managed funds is that they not only have to beat a benchmark index, but they also have to beat the index plus the fee they charge, which can be as much as 2% or more.
Here are a few examples of index funds. Notice the low fees charged.
Fidelity ZERO Total Market Index Fund (FZROX)
Objective (from the Fidelity website): The fund seeks to provide investment results that correspond to the total return of a broad range of U.S. stocks.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.00%
Minimum Investment: $0
Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Objective (from the Vanguard website): Designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks..
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.04%
Minimum Investment: $3,000
Vanguard Total Stock Market ETF (VTI)
Objective (from the Vanguard website): Vanguard Total Stock Market ETF is an exchange-traded share class of Vanguard Total Stock Market Index Fund, which employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.03%
Minimum Investment: Cost of 1 Share is approximately $150
You can find a lot of index fund options at both Vanguard and Fidelity. Vanguard has made a name for itself in the low-fee index fund space, and many investors use them. Fidelity has recently rolled out more options for index fund investing as well.
Resources and Tools for New Investors
To invest you need positive cash flow that can be diverted to index funds. I wrote a post outlining 5 ways to find cash to invest in the stock market that may be helpful if one of your goals is to invest more.
I also created a spreadsheet you can use to quickly and easily analyze your 401k or 403b investment options. You can grab a free copy here.
Bottom line on index funds: Index funds offer investors the benefit of low fees and lower risk due to broad exposure to the market.
Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market. Index funds should match the risk and return of the market based on the theory that, in the long term, the market will outperform any single investment.
An “index fund” is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
Fortunately, it's easy to buy index funds. You can buy index funds through brokerages such as Charles Schwab, Fidelity or Vanguard. Financial advisors who hold client accounts at those companies or other brokerages can also buy index funds for you.
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
Tracking error may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc. This is a major risk in index funds. Index funds do lose out on the expertise of the fund manager and the structured investment approach that an active fund manager brings.
Index mutual funds pool money to buy a portfolio of stocks or bonds. Investors buy shares directly from the mutual fund company at the net asset value (NAV) price, which is calculated at the end of each trading day.
In order to purchase shares of an index fund, you'll need to open an investment account. A brokerage account, individual retirement account (IRA) or Roth IRA will all work. You can then buy the fund in the account.
To be sure, if you have the time, knowledge, and desire to create a portfolio of individual stocks, by all means, go for it. But even if you do own individual stocks, index funds can form a solid base for your portfolio. Index funds offer investors of all skill levels a simple, successful way to invest.
Lower risk: Because they're diversified, investing in an index fund is lower risk than owning a few individual stocks. That doesn't mean you can't lose money or that they're as safe as a CD, for example, but the index will usually fluctuate a lot less than an individual stock.
The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you'll pay.
One difference between index and regular mutual funds is management. Regular mutual funds are actively managed, but there is no need for human oversight on buying and selling within an index fund, whose holdings automatically track an index such as the S&P 500. If a stock is in the index, it'll be in the fund, too.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.
You can't invest directly in an index, but you can invest in an index fund, which aims to track the performance of that index. A professional manager pools the money from many investors to invest in the securities that make up the index that the fund is trying to track the performance of.
Index funds invest in the same assets using the same weights as the target index, typically stocks or bonds. If you're interested in the stocks of an economic sector or the whole market, you can find indexes that aim to gain returns that closely match the benchmark index you want to track.
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification.
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Introduction: My name is Eusebia Nader, I am a encouraging, brainy, lively, nice, famous, healthy, clever person who loves writing and wants to share my knowledge and understanding with you.
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In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
