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Your Guide to Low-Cost Index Funds

Low-cost index funds have become the prom queens of investing. They’re so popular, in fact, Jack Bogle of Vanguard, oft called the father of index funds, sounded a warning that index investing may become “too successful for its own good.”

Bogle’s concern is that the index fund industry will become concentrated, with large institutional investors and a select few index fund providers dominating the space. Whether or not that comes to pass, one thing is clear: Low-cost index investing is one of the best DIY strategies to emerge from Wall Street.

Even prominent investors like Warren Buffett have openly come out in favor of buy-and-hold index investing for the average investor. If the Oracle of Omaha says it, it must be true.

The argument in favor of low-cost index funds is simple: Active funds cost more and are less likely to live up to their promises. According to research by the S&P Dow Jones Indices, 95 percent of active managers failed to outperform their benchmarks on a relative basis over the past 15 years. If you’re shopping for diamond-in-the-rough active funds, you have a 5 percent chance of finding one that actually shines.

Meanwhile, the S&P 500’s average rate of return over the last 15 years was 8.4 percent, which the Vanguard 500 Index Fund (ticker: VFINX) has nearly matched at 8.27 percent. The difference equates to the fund’s expense ratio of 0.14 percent, which is subtracted from its returns. Comparatively, the average actively managed fund costs 0.75 percent.

All of this is to say if you’re shopping for a straight-forward, low-cost investing strategy, you need to know about low-cost index funds.

What Is an Index Fund?

To understand index funds, the distinction must first be made between a stock market index (like the S&P 500) and an index fund (like VFINX).

A stock market index is a curated selection of stocks designed to represent the broader market. Since it’d be nearly impossible to track every stock, companies like S&P Dow Jones Indices created indexes to track the broader market. So when we want to gauge stock market performance, we can simply check the Dow Jones Industrial Average rather than having to click through the latest price data on every stock.

Each index reflects a slightly different perspective of the market. For instance, the DJIA, comprised of 30 significant stocks trading on the New York Stock Exchange, was designed to represent the broader U.S. economy. The S&P 500, on the other hand, tracks the 500 largest publicly traded U.S. companies, while the Russell 2000 index tracks the 2,000 smallest publicly traded companies.

Once an index is defined, it remains static until the index provider changes the components, says Andrew Crowell, vice chairman of D.A. Davidson & Co. Wealth Management in Los Angeles. Most stock market indexes are rebalanced once per year.

Indexes are used for tracking purposes only. You can’t invest directly in an index. Instead index investors buy low-cost index funds that track their chosen index.

Index funds are baskets of stocks that attempt to mirror an underlying stock market index. An S&P 500 index fund will hold roughly the same companies in the same proportion as they’re listed on the S&P 500 index.

Index providers like S&P Dow Jones doesn’t sell index funds. It creates the index and other entities, like Vanguard and Fidelity, manufacture index funds to track those indexes.

[See: 8 Do’s and Don’ts During Market Volatility.]

How Do Low-Cost Index Funds Work?

Index fund managers mirror the investments held in their benchmark index with the goal of matching that index’s performance. They follow the recipe laid out by the index. If the benchmark says use two parts Apple ( AAPL) to one part Google ( GOOG, GOOGL), the manager will buy two shares of Apple for every one share of Google in the fund.

Since the manager isn’t actively analyzing and selecting which investments to hold, index funds are considered passively managed funds.

This minimal legwork on the part of the manager is why index fund expense ratios are so low. Investors can buy low-cost index funds for pennies on the dollar, or nothing at all.

Fidelity Investments recently won the race to zero fees with their no-fee index funds. The Fidelity Zero expense ratio funds are a collection of four mutual funds with zero expense ratios and no minimums to invest.

In case you were wondering, “Fidelity does not make any money on the four Zero expense index funds,” says Robert Beauregard, a Fidelity spokesperson. The company was able to leverage its scale to provide these funds for free.

The Lowest Cost Index Funds on the Market

Here are the lowest cost index funds from some of the largest index fund providers:

Index Fund

Expense Ratio

Fidelity ZERO Total Market Index Fund (FZROX)

0 percent

Fidelity ZERO Large Cap Index (FNILX)

0 percent

Fidelity ZERO Extended Market Index (FZIPX)

0 percent

Fidelity ZERO International Index (FZILX)

0 percent

Schwab Total Stock Market Index Fund (SWTSX)

0.03 percent

Schwab S&P 500 Index Fund (SWPPX)

0.03 percent

Schwab U.S. Broad Market ETF (SCHB)

0.03 percent

Schwab U.S. Large-Cap ETF (SCHX)

0.03 percent

iShares Core S&P Total U.S. Stock Market ETF (ITOT)

0.03 percent

iShares Core S&P 500 ETF (IVV)

0.04 percent

Vanguard 500 Index Fund Admiral Shares (VFIAX)

0.04 percent

Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)

0.04 percent

Vanguard S&P 500 ETF (VOO)

0.04 percent

Vanguard Total Stock Market ETF (VTI)

0.04 percent

Low-Cost Index Mutual Funds Versus ETFs

“Index funds are just delivery vehicles,” says Patrick O’Connor, head of global ETFs at Franklin Templeton in San Mateo, California. They can come in two forms: mutual funds and exchange traded funds (ETFs).

Mutual funds were the first low-cost index funds and remain the lowest cost index funds (as Fidelity has shown), but ETF index funds are increasingly popular for their transparency and liquidity.

Unlike mutual funds which are priced once per day at market close, ETFs trade throughout the day like stocks. As such, investors can buy and sell their index funds at any time during the trading day. They also have a good idea of the price they’ll pay or receive.

[See: 7 Blended ETFs to Own for a Diversified Portfolio.]

The disadvantage to ETF index funds is that they can be trading above or below their net asset value, Crowell says. Index fund investors “can be assured of getting the true cost when buying an index mutual fund” because they’re always priced at NAV whereas you could be paying a premium or discount with an index ETF.

How to Invest in Low-Cost Index Funds?

“The good news and bad news for investors is there are literally thousands of index funds,” Crowell says. This can make finding the best low-cost index fund for you challenging.

How to choose a low-cost index fund:

— Determine your desired exposure.

— Choose the right index to track.

— Evaluate total cost, including expense ratios and trading fees.

— Look for a low tracking error.

— Consider fund manager experience and who the index provider is.

“The starting point for any investment is a comprehensive financial plan,” Crowell says. Your plan will inform your desired asset allocation and the type of index fund you should use.

“The more risk averse or nervous the investor, the broader the stock market index they should use,” as broader indexes provide a “smoother ride,” Crowell says. For example, if you’re hesitant about investing, you might opt for a total stock market index as opposed to a small-cap index.

Once you know the type of low-cost index fund you want, you can begin shopping for your prom queen. An easy place to start is the expense ratio. Lower is obviously better. A good expense ratio for a low-cost index fund is below 0.2 percent.

But the expense ratio is only one component to an investment’s cost. Also beware of trading fees (more common with index fund ETFs) and mutual fund sales loads.

A sales load is a commission a mutual fund pays for brokers to offer the fund to their investors. The cost of this sales load is deducted from your investment either when you buy (a front-end sales load) or sell (a back-end sales load).

Then there’s the tracking error. This measures how closely the index fund tracks its underlying benchmark. The lower the tracking error, the closer the fund’s returns match its benchmark.

A consistently low tracking error is also a sign of a good index fund manager. Look for an index fund manager who is respected in the industry and has the resources to manage the index correctly, O’Connor says.

Lastly, pay extra attention to self-indexed funds. These are index funds where the fund provider has created its own index to serve as the benchmark. For example, instead of tracking the S&P 500, the Fidelity ZERO Large Cap Index Fund tracks the Fidelity U.S. Large Cap Index.

[See: 7 Expert Moves to Make in 2019.]

This can be a cost-saving strategy for fund managers because it lets them avoid having to pay a replication fee to third-party index providers for the right to replicate an index. But it also opens the door to less reliable indexing.

If your index fund is self-indexed, make sure you understand how the benchmark index is calculated. A low-cost index fund is only as good as the index it tracks.

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Your Guide to Low-Cost Index Funds originally appeared on usnews.com