Everything You Need to Know About Investing in Index Funds

Last Modified on January 20, 2020

Index funds have gained immense popularity in the last few years. Many financial experts have time and again highlighted the importance of index funds in a balanced portfolio. However, there are still many misconceptions around index funds that linger in the market. Many people consider it an avenue limited to first-time investors or for middle-income group investors. If you have been contemplating the thought of investing in index funds but do not know where to start, here are the positives, negatives, and all other aspects of index funds that can help you make a more informed decision. 

Let’s start with understanding how index funds work. 

What are Index Funds?

Index funds are a type of mutual fund that provide good market exposure with low operating expenses. They are a unique section of stocks that represent a wide segment of the financial market. For example, the Standard & Poor’s 500 (S & P 500) represents some of the largest American corporations like Amazon, Microsoft, Exxon Mobil, Apple, etc. 

With an index fund, you get a gamut of different stocks under a single index. This is a lot easier to manage than having to buy stocks individually. Index funds are considered ideal for retirement accounts, like 401(k) and individual retirement accounts (IRAs). 

What are the Advantages of Index Funds?

Index funds have many advantages over other forms of investments. For example: 

1. Low costs: Index funds can be cheaper as compared to other actively managed investments. Index funds are simpler to manage and don’t require the investor to spend a lot of time or money on monitoring individual stocks. This ultimately results in low costs and higher returns.
2. Relaxed management: Mutual funds require regular buying and selling of stocks and need to be actively monitored by a manager. This may increase the scope of risk and error. Index funds, on the other hand, are a lot more relaxed and require a passive form of management.
3. Easy diversification: Investors can capture a large portion of the market with a single index fund. Unlike mutual funds, index funds invest in hundreds of holdings with a relatively lower risk. They offer wider exposure and easy diversification to your portfolio.
4. Low risk: Because of easy diversification and low costs, index funds are seen as a considerably safer investment with low risk and steady growth for your money.
   

What are the Disadvantages of Index Funds? 

Just like any other investment method, index funds too, come with some disadvantages, like: 

• Little flexibility: Index funds offer less flexibility compared to other actively managed investments. Any investment decisions on these funds are made within the boundaries of matching index returns.
  

• Limited control: Index funds are a set of different stocks and investors cannot take decisions concerning individual stocks.
  

• No downside protection: Index funds like the S&P 500 may seem like a good investment when the market is soaring high. But they can leave you exposed to a great deal of risk if the market drops. Index funds cannot be removed even if they are in a non-performing stock, which is why they rise and fall with the market.
  
• No active management: When funds are managed actively, the investor is able to use their experience and expertise to increase the chances of a higher return. They can study real-time trends and the company’s recent developments to make informed decisions. This is not possible in a passively managed index fund.
  

How to Buy an Index Fund?

You can buy an index fund from a brokerage or a mutual fund company. You must consider the trading costs and commission fees before buying a fund. It is also important to choose the right type of index fund. S&P 500 is one of the most popular index funds because it contains 500 companies and includes some of the biggest names in America. But there are several other index funds available to choose from.

You can pick a fund based on the following factors:

• Size: You can choose an index fund of small, medium, or large-sized companies.
  

• International exchanges: If you specifically want to invest in foreign funds, you can select index funds that trade on foreign exchanges.
  
• Sector: Index funds related to particular sectors, like healthcare, technology, consumer goods, etc.

Keeping aside these factors, the costs involved in investing in an index fund can also vary. Here are some things an investor should know: 

1. Minimum investment: You can require at least a few thousand dollars to start investing in an index fund. Although investors can add smaller amounts later, the starting threshold is higher than some other avenues of investment. 
2. Manager fees: The manager of your index fund will charge a certain fee. This could be a fixed amount or a percentage of your returns.
3. Tax implications: If index funds are held outside tax-advantaged retirement accounts like 401 (k) or IRA, they can trigger capital gains tax. This tax can substantially affect your overall gains. 

To Sum it Up

Index funds are particularly great for first-time investors as they require passive management and offer good diversification and returns. They are also easy to follow and understand. But it is important to check the index fund returns on the mutual fund quote page before putting your money in. Study the returns over a period of time and do not panic if your returns are not the same. Remember, just like any other investment, index funds are also subject to market downturns. The ideal way to reap their benefits is to invest in them along with other actively managed investments. 

Are you beginning your investing journey with index funds? Talk to financial advisors to know how and where to start.