How to Participate in Index Funds and Top Index Funds for 2023

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What is an index fund?

In essence, an index fund is a collection of equities that has been painstakingly chosen to closely resemble the performance of a pre-established stock market index, such as the prestigious Standard & Poor’s 500 index. These market indexes are a collection of businesses that together reflect a certain area of the financial market. These indexes’ main purpose is to give a thorough picture of the overall health of the economy.

Within an index fund’s composition, you’ll discover a mirror image of the investments featured in the market index it diligently tracks. This intrinsic alignment ensures that the index fund’s performance closely shadows that of the underlying index. Remarkably, this harmony is achieved without the need for active, hands-on management. This distinctive characteristic makes index funds an attractive choice for many investors seeking a diversified and low-maintenance investment option.

How Index Funds Operate

Index funds work by mirroring the performance of a specific market index, like the Standard & Poor’s 500 index, rather than trying to outperform it. They achieve this by investing in the stocks of every company listed on that index.

This passive management strategy eliminates the need for active decision-making in buying or selling investments within the fund. Index funds are favored for their ability to balance portfolio risk since market swings are usually less volatile across an index compared to individual stocks.

Why should you buy index funds?

Although fund managers put a lot of effort into trying to “beat the market” (specifically, a market index), they very seldom succeed. And even if they do, there is a very slim chance that they will outperform the market in the long run.

SPIVA, a division of S&P Global, reports that just 29% of actively managed funds outperformed the S&P 500 in 2019. Only 9% of those ETFs outperformed their benchmark in 2021.

Passively managed index funds often provide investors greater long-term financial returns since actively managed funds frequently underperform the market while index funds equal it. They are also less expensive because management costs for actively managed assets are sometimes greater.

An index, what is it?

An index is a grouping of securities, such as stocks, that are used by investors to gauge the health of the overall market. When newscasters discuss the ups and downs of “the Dow,” they are referring to the performance of the Dow Jones Industrial Average as an index on that particular day.

An index fund, as its name implies, follows a certain benchmark index. The following are some typical index fund benchmarks:

Index examples

  • The S&P 500: As noted above, Standard & Poor’s 500 is an index of performance of the 500 largest U.S. public companies.
  • The Dow Jones Industrial Average: This well-known index (also known as the DJIA) tracks the 30 largest U.S. firms.
  • Nasdaq: The Nasdaq Composite tracks more than 3,000 technology-related companies.
  • Russell 2000 Index: Tracks 2000 smaller companies (also known as “small cap,” referring to companies with market capitalization of less than $2 billion).
  • The Wilshire 5000 Total Market Index: The Wilshire 5000 tracks the nearly 7,000 publicly traded U.S. companies, weighted by capitalization or market size.
  • The MSCI EAFE Index: Tracks performance of large- and mid-cap stocks of firms based in 21 developed nations outside the U.S. and Canada, including nations in Europe, Australasia and the Far East.

How much do index funds cost?

Index funds have fewer fees that reduce your returns than actively managed funds. Index funds have lower expense ratios because they require less work than managed accounts. You are not paying for someone to analyze financial statements and make purchasing decisions. Index funds may be less expensive than other funds, but they may still incur some expenses. The following are the most important:

Investment Requirements

  1. Minimum Investment: The minimum amount needed to invest in a mutual fund can vary widely, ranging from nothing at all to several thousand dollars. Once you’ve met this initial requirement, most funds permit investors to contribute smaller sums over time.
  2. Account Minimum: Distinct from the investment minimum, a brokerage may have a $0 account minimum, which is common for customers opening traditional or Roth IRAs. However, it’s important to note that this doesn’t eliminate the investment minimum for a specific index fund.
  3. Expense Ratio: Among the key costs associated with an index fund is the expense ratio. Expense ratios represent fees deducted from the returns of each fund shareholder, calculated as a percentage of their overall investment. You can find the expense ratio in the mutual fund’s prospectus or when researching a mutual fund on a financial website.
  4. Tax-Cost Ratio: Apart from fees, owning the fund can potentially trigger capital gains taxes if held in accounts without tax advantages, such as a 401(k) or an IRA. Similar to the expense ratio, these taxes can impact investment returns.

Achieving Diversification through Index Funds

Achieving Diversification through Index Funds

Diversification through index funds offers investors a range of choices. These funds are accessible across various asset classes, allowing investors to select those that concentrate on companies with small, medium, or large capitalizations. Additionally, investors can opt for sector-specific index funds, such as technology or energy.

While these indexes may not provide the same level of diversification as broader market indices, they still offer more diversification than investing in a handful of individual companies within a sector.

Individual stocks are subject to market fluctuations, experiencing both rises and falls. In contrast, indexes have historically shown a propensity to increase in value over time. Investing in index funds may not deliver soaring returns during bullish market phases, but it also mitigates the risk of significant losses when the market takes a downturn.

For instance, the S&P 500, a renowned benchmark, has recorded an average annual return of nearly 10% since 1928, showcasing the potential for steady, long-term growth through index fund investments.

Which index funds are the best?

Index funds invest in specific market indices. So, before you begin investing, you’ll need to know which market index you want your index fund to track.

Here are some of the best S&P 500 index funds.

Index fundMinimum investmentExpense ratio
Vanguard 500 Index Fund – Admiral Shares (VFIAX)$3,000.0.04%.
Schwab S&P 500 Index Fund (SWPPX)No minimum.0.02%.
Fidelity 500 Index Fund (FXAIX)No minimum.0.015%.
Fidelity Zero Large Cap Index (FNILX)No minimum.0.0%.
T. Rowe Price Equity Index 500 Fund (PREIX)$2,500.0.20%.
Data current as of market close on August 31, 2023. For informational purposes only.

Vanguard 500 Index Fund Admiral Shares (VFIAX)

Referred to as the Vanguard S&P 500 Index Fund, this investment vehicle was established in 1976 and holds the distinction of being one of the pioneering index funds in the market. Similar to the other funds tracking the S&P 500 mentioned on this list, this fund provides investors with exposure to the 500 largest U.S. companies. These companies collectively account for approximately 75% of the total value of the U.S. stock market.

Schwab S&P 500 Index Fund (SWPPX)

According to Morningstar, this is one of the most affordable and accessible S&P 500-tracking funds available. This Schwab fund, which debuted in 1997, has a 0.02% expense ratio and no minimum investment, making it appealing to cost-conscious investors.

Fidelity 500 Index Fund (FXAIX)

Fidelity removed the investment minimum for this fund, which was founded in 1988 (formerly known as Institutional Premium Class fund), so investors with any budget size can participate in the low-cost index fund action.

Fidelity Zero Large Cap Index (FNILX)

This Fidelity fund made headlines when it became one of the first to charge no annual expenses, allowing investors to keep all of their money invested for the long term.

T. Rowe Price Equity Index 500 Fund (PREIX)

Founded in 1990, the fund’s expense ratio is competitive with other providers, but the $2,500 minimum may be steep for beginning investors.

What are the best Nasdaq index funds?

Here are some of the best index funds pegged to the Nasdaq.

Index fundMinimum investmentExpense ratio
Invesco NASDAQ 100 ETF (QQQM)No minimum0.15%
Invesco QQQ (QQQ)No minimum0.20%
Fidelity NASDAQ Composite Index Fund (FNCMX)No minimum0.37%
Data current as of market close on August 31, 2023. For informational purposes only.

Invesco NASDAQ 100 ETF (QQQM)

QQQM comprises 100 of the Nasdaq’s largest nonfinancial companies. It also includes at least 90% of the NASDAQ-100 index’s assets and is rebalanced quarterly.

QQQM has an expense ratio of 0.15%, which means that for every $1,000 invested, you would pay $1.50 in annual fees.

Invesco QQQ (QQQ)

QQQ holds 101 companies, tracks the NASDAQ-100, and has $151.51 billion in assets under management.[3]

QQQ has an expense ratio of 0.20%, meaning for every $1,000 invested you’d pay a $2 fee annually.

FNCMX (Fidelity NASDAQ Composite Index Fund)

The goal of FNCMX is to replicate the performance of the Nasdaq Composite index. The fund typically holds 80% of the stocks in the index. FNCMX includes the real estate and material sectors, in addition to the typical sectors represented by a Nasdaq index fund (such as information technology, consumer services, and health care).

FNCMX has an expense ratio of 0.37%, which means that for every $1,000 invested, you would pay $3.70 in annual fees.

Quick start guide: How to invest in index funds

Index funds are simple to invest in. Here’s a quick guide to getting started:

  1. Set an objective for your index funds.
    Before you begin investing in index funds, you should consider what you want your money to do for you. Individual stocks or even cryptocurrency may be more appealing if you want to make a fortune in a few years and are willing to take a lot of risk.

Index funds, on the other hand, may be a good investment for your portfolio if you want to let your money grow slowly over time, especially if you’re saving for retirement.

Look into index funds.

Once you’ve decided which index you want to track, it’s time to look at the index funds in which you’ll be investing. Several factors should be considered when researching an index fund. Here are some things to remember:

  • Company size and capitalization. Index funds can track small, medium-sized or large companies (also known as small-, mid- or large-cap indexes).
  • Geography. There are funds that focus on stocks that trade on foreign exchanges or a combination of international exchanges.
  • Business sector or industry. You can explore funds that focus on consumer goods, technology, health-related businesses.
  • Asset type. There are funds that track domestic and foreign bonds, commodities and cash.
  • Market opportunities. These funds examine emerging markets or other nascent but growing sectors for investment.

Despite the abundance of options, you may only need to invest in one. Warren Buffett, the investing legend, has stated that the average investor only needs to invest in a broad stock market index to be properly diversified. However, if you want more exposure to specific markets in your portfolio (for example, more emerging market exposure or a higher allocation to small companies or bonds), you can easily customize your allocation.

3. Pick your index funds

Once you’ve decided which index you want to invest in, you’ll need to decide which index fund to buy. This frequently comes down to money.

Index funds’ low costs are one of their main selling points. They are inexpensive to run because they are automated to track changes in the value of an index. Don’t, however, assume that all index mutual funds are inexpensive.

They incur administrative costs even though they are not actively managed by a team of well-paid analysts. These expenses are deducted from the returns of each fund shareholder as a percentage of their total investment.

Two funds may have the same investment goal — such as tracking the S&P 500 — but have wildly different management costs. Those fractions of a percentage point may appear insignificant, but even minor fee inflation can have a significant impact on your long-term investment returns. Generally, the lower the fees, the larger the fund.

4. Decide where to buy your index funds

An index fund can be purchased directly from a mutual fund company or a brokerage. ETFs (exchange-traded funds) are similar to mini mutual funds that trade like stocks throughout the day (more on these below).

Consider the following when deciding where to buy an index fund:

Fund allocation. Do you want to buy index funds from different fund families? Some of their competitors’ funds are available through large mutual fund companies, but the selection may be more limited than what is available through a discount broker.

Convenience. Find a single provider who can meet all of your requirements. If you only plan to invest in mutual funds (or a combination of funds and stocks), a mutual fund company may be able to serve as your investment hub. If you need sophisticated stock research and screening tools, however, a discount broker who also sells the index funds you want may be a better option. (If you don’t already have a brokerage account, learn how to open one here.)

Trading expenses. Consider how much a broker or fund company charges to buy or sell the index fund if the commission or transaction fee isn’t waived. Mutual fund commissions are higher than stock trading commissions, typically around $20 or more per trade, compared to less than $10 per trade for stocks and ETFs.

Investing with a social impact. Do you want your investment to have an impact outside of your portfolio? Some index funds follow benchmarks that target companies that support environmental or social justice causes. Find out more about impact investing.

Options with no commission. Do they provide no-fee mutual funds or commission-free ETFs? This is an important criterion for evaluating discount brokers.

5. Buy index funds

To purchase index fund shares, you must do so through an investment account. The brokerage you chose in step 3 can then open an investment account, such as a traditional brokerage account or a Roth IRA, for you. The fund can then be purchased from that account.

When you go to buy the fund, you may be able to choose a fixed dollar amount or a number of shares. The index fund’s share price and your investment budget will most likely determine how much you’re willing to spend. For example, if you have $1,000 to invest in an index fund and the fund you’re considering sells for $100 per share, you’d be able to buy 10 shares.

6. Keep an eye on your index funds

Index funds have become one of the most popular ways for Americans to invest because of their ease of use, instant diversity and returns that typically beat actively managed accounts. But passive management doesn’t mean you should completely ignore your index fund. Here are some things to think about over time:

Is the index fund fulfilling its mandate? The performance of your index fund should be similar to that of the underlying index. To check, go to the mutual fund quote page and look at the index fund’s returns. It compares the performance of the index fund over time to the performance of the benchmark index. Don’t be concerned if the results aren’t identical. Remember that even minor investment costs, as well as taxes, have an impact on results. However, red flags should be raised if the fund’s performance lags the index by a significant margin greater than the expense ratio.

Is the index fund you want too expensive? If the fees start stacking up over time, you may want to reevaluate your index fund.

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