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 the S&P Dow Jones Indices Risk-Adjusted SPIVA Scorecard: At the end of 2020, after adjusting for volatility, the majority of actively managed domestic funds across market-cap segments underperformed their benchmarks on a net-of-fees basis over mid- and long-term investment horizons.
If you’re looking for a straightforward, inexpensive investing strategy, you need to know about low-cost index funds. Here are a few points to keep in mind:
— What is an index fund?
— What are the different indexes to choose from?
— How to invest in low-cost index funds.
— The lowest-cost index funds on the market.
— Low-cost index mutual funds vs. ETFs.
— Things to consider when buying an index fund.
What Is an Index Fund?
To understand index funds, you first need to understand the difference between a stock market index (like the S&P 500) and an index fund, such as the SPDR S&P 500 ETF Trust (ticker: SPY).
A stock market index is a curated selection of individual stocks designed to represent the broader market. Index providers like S&P Dow Jones Indices created indexes to make it easier to gauge overall stock market performance rather than clicking through the latest price data on every stock.
Each index reflects a slightly different perspective of the market. For example, the S&P 500 tracks the 500 largest publicly traded U.S. companies, while the Wilshire 5000 includes all the stocks from the U.S. stock market, including small-, mid- and large-cap companies.
Once an index is defined, it remains static until the index provider changes the components. Most indexes are rebalanced annually and follow a preset methodology to include or exclude constituents.
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 providers like S&P Dow Jones don’t sell index funds. They create the index, and other entities, such as Vanguard and Fidelity, build index funds to track those indexes.
What Are the Different Indexes to Choose From?
Index fund managers mirror the investments held in their benchmark index with the goal of matching that index’s performance by buying a similar number of shares at the same ratio. For example, if the benchmark has twice the proportion of Apple Inc. ( AAPL) to Alphabet Inc. ( GOOG, GOOGL), the fund manager will buy two shares of Apple for every one share of Alphabet in the fund.
Since the manager isn’t actively analyzing and selecting which investments to hold, index funds are considered passively managed funds that follow major indexes as their benchmark. These include:
S&P 500. The S&P 500 follows the performance of 500 of the largest U.S. companies and is considered a benchmark for the performance of the overall stock market. Many people invest in funds that track the S&P 500 as their benchmark because the index represents leading U.S. companies in their respective industries. The S&P 500 is market-cap weighted, meaning that the larger the company the more it’s represented in the index. Unlike other indexes that use a preset methodology to choose holdings, stocks in the S&P 500 are selected by a committee and constituents can be included or excluded at any time. Currently, there are 505 stocks in the index because it includes two share classes of stock from five companies it holds.
Nasdaq Composite. The Nasdaq is the first global electronic exchange and holds more than 3,300 companies, which are traded on the index. For this reason, many all-star technology companies choose to be listed on this particular index. Similar to the S&P 500, many investors choose to invest in low-cost index funds that track the Nasdaq, namely to gain exposure to Big Tech companies.
Others. Many other indexes represent different areas of the stock market. Among some of the biggest in the U.S. are the Russell growth and Russell value indexes which individually track the performance of small, medium and large companies in both the growth and value segments, respectively, of the U.S. equity universe.
There are also geographically based indexes, such as the FTSE 100 that represents 100 of the largest companies on the London Stock Exchange and the Nikkei 225, the major index for Tokyo’s Stock Exchange, which tracks the performance of top companies in Japan. MSCI’s ACWI index includes large- and mid-cap stocks across 23 developed and 27 emerging markets. As of June 2021, it covers more than 2,900 constituents across 11 sectors.
Newer indexes include ones focusing on environmental, social and governance factors, such as the MSCI KLD 400 Social Index, the first socially responsible index.
Minimal legwork on the part of the manager is why expense ratios for index funds are so low. Investors can buy low-cost index funds for pennies on the dollar, or nothing at all.
How to Invest In Low-Cost Index Funds
Don Bennyhoff, director of investor education at Portfolio Solutions, says indexing today is challenging because of how it’s changed over the years.
“Indexing isn’t one thing; indexing is many things. And so it really pays for an investor to do their homework, before they go in and purchase an index fund. You can’t just assume that because it’s an index fund, then they’re pretty much all the same; there are some major differences,” he says.
Here’s how to choose a suitable 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 the fund manager’s experience as well as the index provider.
Index funds are a tool for investors, Bennyhoff adds, so investors first need to decide what type of investment they want.
Todd Rosenbluth, director of ETF research at CFRA Research, says when choosing an index fund, investors first must understand what exposure it provides. “Does that exposure match up with what you’re seeking from that fund and how it will fit within a broader portfolio?” he says.
Investors can start by looking at the name, as most index funds will explain the exposure upfront. “Either it will have the name of the index that it is tracking, or it’ll have the name of the style within the product,” Rosenbluth says.
The fund’s website should offer information about the exposure, the sector or regions of the world it offers exposure and the holdings, he adds.
Once you know the type of low-cost index fund you want, you can begin shopping. An easy place to start is the expense ratio. A good expense ratio for a low-cost index fund is less than 0.2%, although indexes that cover specialized exposure, such as international indexes, will cost more because of the extra work involved to vet holdings.
“You want to try to pay as little as possible, but be able to then understand the nuanced differences between products,” Rosenbluth adds.
The expense ratio is only one component of an investment’s cost. Also, beware of trading fees (more common with 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, known as a front-end sales load, or sell, known as 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.
Bennyhoff says some index funds use a strategy called “full replication,” which means the fund holds all of the individual stocks within an index. For example, he says, most index funds that follow the S&P 500 are full replication funds and will closely track the index.
Rosenbluth says most index funds seek to replicate the benchmark’s performance, but the fund may not always trade in line with the performance. The expense ratio plays a role in that as the cost is deducted from the return. How the management team responds to changes in the benchmark may also cause some deviation. Benchmarks can be rebalanced periodically and funds will have to change positions if that occurs. Some managers may try to trade ahead of the changes being implemented.
He notes that some managers may try to generate positive returns by engaging in securities lending. Sometimes that allows the fund to outperform the index, but if the manager is unsuccessful, the fund underperforms.
It’s easier to tell if a fund is properly tracking its index when it tracks big, well-known indexes such as the S&P 500 or Russell 1000, Rosenbluth says, but if the fund tracks a lesser-known index or is a self-indexed fund, this may be more difficult to decipher.
Self-indexed funds are based on indexes a fund provider created to serve as the benchmark. For example, instead of tracking the S&P 500, the Fidelity Zero Large Cap Index Fund ( FNILX) tracks the Fidelity U.S. Large Cap Index.
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.
The Lowest-Cost Index Funds on the Market
Here are the lowest-cost index funds from some of the largest index fund providers:
Fidelity ZERO Total Market Index Fund ( FZROX)
Fidelity ZERO Large Cap Index ( FNILX)
Fidelity ZERO Extended Market Index ( FZIPX)
Fidelity ZERO International Index ( FZILX)
Schwab S&P 500 Index Fund ( SWPPX)
Schwab Total Stock Market Index Fund ( SWTSX)
Schwab U.S. Broad Market ETF ( SCHB)
Schwab U.S. Large-Cap ETF ( SCHX)
iShares Core S&P Total U.S. Stock Market ETF ( ITOT)
iShares Core S&P 500 ETF ( IVV)
Vanguard S&P 500 ETF ( VOO)
Vanguard Total Stock Market ETF ( VTI)
Vanguard Total Stock Market Index Fund Admiral Shares ( VTSAX)
Low-Cost Index Mutual Funds vs. ETFs
Index funds can come in two forms: mutual funds and exchange-traded funds.
Mutual funds were the first low-cost index funds, 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.
Alex Gordon, director of ETF sales at ETF Managers Group, a thematic ETF provider, says ETFs have multiple advantages over mutual funds, namely better taxation. “ETFs are able to limit capital gains distributions (in most cases to zero) while that is a consistent problem for mutual funds,” he says.
“With the capital gains tax rate potentially changing, that could put an even bigger emphasis on favoring ETFs to make up a portfolio,” Gordon explains.
Things to Consider When Buying an Index Fund
Diversification. Index funds allow you to automatically diversify your investments. Owning index funds of different asset classes helps manage your risk exposure.
Gordon says diversification is one of the key benefits of ETFs that offer “easy and liquid access” to the market. “Investors get the benefit of buying and selling into hundreds of stocks or bonds within one ticker,” he says.
However, you want to avoid too much diversification to prevent overlap or a potential drag in performance.
Accessibility. Index funds offer a way for all investors to easily and efficiently access different securities and asset classes. If you are new to investing and are taking a long-term, passive investment approach, investing through index funds is one of the simplest ways to get started.
Benchmark. Index funds can be a great investing tool, but like any vehicle, investors need to know what they own.
Consider the benchmark you want your investments to follow. Become familiar with different benchmarks to have a general understanding of how index funds will perform. An index fund that follows a particular index allows you to review the benchmark’s composition, individual holdings, historical performance and other key factors that can help determine which investments fit best with your portfolio’s strategy.
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Update 10/18/21: This story was published at an earlier date and has been updated with new information.