Index funds are one of the most effective ways to get a full diversified long term portfolio for long term investing at a low cost. It’s easy to start for beginners, read more to find out.
Contents: Index funds
- What is an index fund?
- Why invest in index funds?
- Index funds: Mutual funds vs ETFs
- How do I start investing in mutual funds?
- Low cost index fund examples
What is an index fund?
An index fund is a security that you can invest in, which tracks a financial index such as the S&P 500. It can be structured as an index mutual fund or index ETF but both serve the same purpose of providing broad market exposure at a low cost an no trading fees.
Index investors are usually interested in passive investing. Index funds track a market index. The manager of the index fund will buy shares according to the weighting of the index. For example, if Apple (AAPL) shares make up 5% of the Dow Jones Industrial Average then the fund manager would keep 5% of the fund in Apple. This means investors can get the same performance of the index without buying and selling all the individual stocks themselves.
Why invest in index funds?
Billionaire investor Warren Buffet famously said he would recommend most non-professional investors be index fund investors, rather than picking stocks. He also instructed his trustees in charge of his estate to invest 90% of the holdings in S&P 500 index funds and the other 10% in US Treasury bills.
If the fact that Warren Buffett is advising it is not enough, let’s explore the specific benefits of investing in index funds…
Diversification (Market exposure)
As a reminder, diversification is done to reduce the risk associated with individual investments on your overall portfolio. For example, let’s say you invest in two stocks – if one of them goes to zero, you have lost half your investment – the other stock would have to double to just break even. Whereas if you have 500 stocks in your portfolio, the affect of each stock on the performance of your portfolio is much less.
Lower fees (operating expenses / turnover)
When investing in a fund, the key cost is the expense ratio. The expense ratio tells you how much you will pay per year as a percentage of your investment in fees. It covers everything from paying the fund manager to operating costs to transaction fees, accounting and taxes.
Popular index funds will typically have an expense ratio well under 0.5%, which makes for a big saving versus the 1%-2% fees typically charged by active managers, who can also charge a performance fee on top.
Long term success
These funds track the performance of well-known indices, where the long-term success is well established. While the investing axiom that stock markets will always rise over time still holds, it is a great argument in favour of investing in the broad stock market itself with index funds.
Problems with index investing
The increasing growth of total funds as well as an increasing percentage of all funds invested in index funds is testament to their popularity and that the pros seems to well outweigh the cons. However, no investment is perfect…
One of the purported advantages of investing in a fund that is actively managed is that the fund manager can takes measures to reduce volatility by hedging. A passive investment in an index accepts all the ups and downs. Every few years there is a bear market where an index can fall over 20%. Investors need to be prepared to weather these bad times for the long term return.
Cannot beat the market
By its nature an index fund tracks the underlying index so can never beat it. Given the strong performance of the overall market in recent years coupled with the proliferation of new hedge funds, most active managers do not beat the index anyway.
Passive investing bubble?
There are some who see the flows into passive investments like ETFs as a ‘bubble’ and think they might pose some systemic risks. This is not in any way proven so shouldn't probably be a reason to not invest in index funds given their strong track record of stability and performance.
Index funds: Mutual funds vs ETFs
What’s the difference between ETFs and mutual funds? In many ways the difference in outcome of investing in a mutual fund or ETF is negligible. Both do a good job of tracking the index and come with low fees.
Oftentimes the main reason for selecting one or the other will be what is available from your investing platform. Online platforms that include stock trading tend to focus on ETFs, while pensions funds that you might invest in through your employer will often only offer mutual funds.
How do I start investing in index funds?
There is no need to hire a financial advisor to pick an index fund, though you can if you prefer. Index funds are not specialist investment products so they do not require any analytical skills or investing knowledge to invest.
We have identified the following steps to take to start investing in index funds.
- Decide goals for using index funds
Here the main consideration is investing time horizon. Do you retire in five years or fifty years? The general recommendation is to take lower risk the closer you are to retirement. If you about to retire soon, your goal is capital preservation, whereas if you have just begun investing and have decades ahead of you, capital appreciation is your main goal. Index funds carry higher risk than bond funds or money market instruments.
- Pick an index
There are two considerations for picking the best index fund, returns and volatility. As they always say ‘past performance is no predictor of future returns’ but it’s the only information we have. Risk and return normally go hand in hand, so stock indices with higher performance tend to have larger drawdowns and vice versa.
For any index you can find the annual performance over certain time periods as well as ‘maximum drawdown’ which is the most it lost from peak to trough in any given period.
- Research best available index funds
Most index funds do a good job of tracking their index so the main consideration is fees. We list some funds to get started below and for more choices, one of the most-trusted companies for researching index funds is Morningstar.
- Open an investment account
FlowBank offers over 50,000 investment products, including most of the major index funds and index ETFs in combination with the security of a Swiss bank account. Find out more about a FlowBank account.
- Buy the index funds
This can easily be done inside the FlowBank mobile app or desktop trading platform, alongside any other investments you care to make from individual shares to forex trading.
- Setup a reinvestment plan
Decide how much you will add to your investment every month in order to take the fullest advantage of compound interest and build wealth.
Low cost index fund examples
For investing in the US stock market, there are the following S&P 500 tracker funds and S&P 500 ETFs:
- Vanguard 500 Index Fund – Admiral shares (VFIAX)
- Fidelity 500 Index Fund (FXAIX).
- iShares Core S&P 500 ETF (IVV)
- SPDR S&P 500 ETF Trust (SPY)
For investing in shares from Switzerland, there are the following funds that track Swiss indices:
- iShares SLI UCITS ETF
- Xtrackers Swiss Large Cap UCITS ETF
- UBS 100 Index-Fund Switzerland (CHF) P