Buying an Index Fund
An index fund is, by its very nature, a well diversified portfolio of stocks. Buying an index fund provides investors with an opportunity to diversify away the risk associated with individual stocks; thereby lowering the overall risk of their investment portfolio.
In this article we're going to discuss the topic of index funds. As part of that discussion, we'll first talk about the different types of funds found on the market today. Next, we'll talk about fee structures, and how they can affect the performance of a fund. Finally, we'll provide a list of some of the better performing funds.
Stock Market Efficiency
The stock market is an efficient trading place. There is a great deal of money at stake and market analysts, as well as investors, are constantly reviewing new information. As the impact of this information is understood, investors buy and sell stocks. In doing so, the market's efficiency remains intact.
Many investors believe in the efficient market theory and have given up on the idea of picking individual stocks. Instead, they have turned their attention to the simplicity of index funds. But there are literally hundreds of funds to choose from, and the asset classes can be very different.
One way to pick an index fund is to select from a certain asset class, or category, of funds. For example, the investor can choose from a selection that includes: large and small companies, growth and value, equity and fixed income, high-yield and investment grade, domestic and international.
An index fund might contain as many as 3,000 company stocks. But the clear majority of these companies will have no impact on the fund's return. Most index funds are market-cap-weighted, meaning the overall return is generated by a small number of large companies (in terms of market capitalization) held in the portfolio.The investment outlook will also play a role in determining the type of fund picked. Mutual funds are better suited to investors that want to purchase shares over an extended period of time. However, if the intention is to move a large sum of money into the market, then an exchange-traded fund may be the better choice. The investor pays a brokerage fee to buy and sell shares in the exchange-traded fund, but the management fees are usually lower than more traditional open-ended mutual funds.
If an investor purchases shares weekly or monthly, then brokerage fees of exchange-traded funds will likely offset any savings from lower management fees. If the intention is to purchase the index over time, economics would likely dictate buying an open-ended fund such as an index mutual fund.
This next point may come as a surprise, but not all index funds have low expense ratios. In fact, there are a large number of funds with expense ratios that are over 2.0%. It's difficult to imagine how a management team can justify expenses this high. An index fund is not considered an active fund and should have an expense ratio that is no higher than 0.5%.
Low Research and Turnover Costs
An index fund doesn't require a great deal of stock research. The objective of the fund itself will define a limited set of investments or securities from which to choose. Turnover, which is the buying and selling of securities by the fund's management, should also be quite low, which means reduced brokerage and trading fees. Limited research costs and lower trading fees are two more reasons why this type of fund should be efficient when it comes to fees.
When deciding which index fund to buy, it's best to consider purchasing a fund that is broadly diversified. While it's possible to find an index of the NASDAQ 100 or the Dow Jones Industrials (30 companies), a fund that tracks a measure of market performance, like the S&P 500, covers a much larger range of equities.
A broad index fund also has an advantage over funds that specialize in a single area, such as small capitalization stocks. If a company gets too large, then it is removed from the portfolio. This creates higher turnover, which brings up another point.
It's important to look for funds that have low turnover. This is a critical attribute - especially for an index fund. High turnover means high trading costs, which eat away at the investor's overall return in the same way as high expense ratios. In fact, turnover in an index fund is costlier than an active fund because it has to make incremental investments in stocks that are too small to purchase efficiently. This can be devastating to a fund's performance. A small cap fund with high turnover will typically underperform the index it's tracking by 2 to 3%.
Index Funds versus ETFs
A true index fund, just like a mutual fund, is priced at the end of the day. Exchange traded funds have intra-day pricing, and are actively traded throughout the day. While ETFs can have lower expense ratios, brokerage fees can eat into the overall return on investment.
Since the number of shares of an ETF remains constant, the investor doesn't have to worry about redemptions by other shareholders, which could force the fund to realize a capital gain. ETFs are not required to distribute capital gains to shareholders, but mutual funds are required by law to distribute such gains.
Best Performing Funds
Now that we've covered the fund types and fees, we're going to finish this topic by listing some of the best performing index funds over the last several years. The criteria used to select these index funds is the three year return on NAV as of October 2020.
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