Buying an Index Fund

You've probably done a lot of reading about index funds that make them sound so simple - buy an index fund and forget about it.  After all an index fund is, by its very nature, a well diversified portfolio of stocks.

The Stock Market is Efficient

The stock market is also a very efficient trading market.  There is a lot of money at stake and market analysts and investors are constantly digesting new information, adjusting their portfolios, and keeping that market efficient.  Because they believe in this efficient market theory, many investors have simply given up on trying picking individual stocks and that mindset gave birth to the popularity of index funds.

But there are literally hundreds of index funds to choose from and the asset classes on which each index itself is built can be very different.  So you've still got plenty of work in front of you even if you've decided to take what you thought was the easy way out by investing in an index fund.

Types of Index Funds

One way to narrow the field considerably is to decide on the asset class or category of the index fund.  For example the investor can choose from:  large and small companies, growth and value, equity and fixed income, high-yield and investment grade, domestic and international.

Also keep in mind that an index fund might contain 500 company names in their annual report, but the majority of the companies will have no impact on the returns of the fund.  Most index funds are market-cap-weighted, meaning that the returns generated are influenced by a small number of the largest companies (in terms of market capitalization) held in the portfolio.

Your investment strategy may also play a role deciding which type of fund you purchase.  If you intend to move a large sum of money into an index fund and you don't intend to add to that investment over time, then an exchange-traded fund is probably your best bet.  You will pay a brokerage fee to buy and sell shares in the fund, but the management fees are usually less expensive with exchange-traded funds than they are in more traditional open-ended funds.

Index Fund Fees

If you intend to invest weekly, monthly or even annually, the brokerage fees of exchange-traded funds will probably overpower any savings you might realize in management fees versus an open-ended fund - that's a big problem for investors.  So if your plan is to purchase the index over time, economics would probably dictate you buy into an open-ended fund such as an index mutual fund.

This next point may come as a surprise to you, 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%.  We're not sure how the management team of these funds can justify expenses this high because an index fund is not considered an active fund.  Look for funds with expense ratios at or under around 0.5%.

Low Research and Turnover Costs

Remember, an index fund doesn't require a great deal of stock research.  The objective of the index fund itself defines a fixed set of investments or securities.  That also means turnover - which is the buying and selling of securities by the fund's management - should also be quite low.  And low turnover means reduced brokerage / trading fees.  Those are just two more reasons an index fund should be efficient when it comes to fees.

Performance of Index Funds

If you're thinking about buying an index fund, you'll also want to consider funds that are broadly diversified.  You can certainly find an index of the NASDAQ 100 or the Dow Jones Industrials (30 companies).  But a fund that tracks a broad index, like the S&P 500 covers a much larger range of equities.

A broad index fund also has an advantage over fund that specialize in a single area such as small capitalization stocks.  If a company gets too big, it is removed from the fund and that creates higher turnover - which brings up another point.

Turnover Hurts Performance

Seek out funds that have low turnover.  This is a critical attribute for an index fund.  High turnover means high trading costs which eat away at the return on the fund the same way high expense ratios do.  In fact, turnover in an index fund usually costs more than an active fund because an index fund has to make incremental investments in stocks that are too small to get a good price.  This can be devastating to a funds performance - A small cap fund with high turnover will typically under perform the index it's tracking by 2 - 3%.

Index Funds versus ETF

A true index fund, just like a mutual fund, is priced at the end of the day.  Exchange traded funds have intra-day pricing since they are actively traded throughout the day.  And while ETFs can have lower expense ratios, you should also be aware that brokerage fees can eat into your overall return on investment.

Since the number of shares of an EFT remains constant, the investor doesn't have to worry about redemptions in shares by other shareholders that force the fund to realize a capital gain.  EFTs are also not required to distribute a capital gain to shareholder but mutual funds are required by law to distribute such gains.

Best Index Funds

Now that you know all you'd ever want to know about buying an index fund, we're going finish this one up by listing some of the best performing index funds on the market.  The criteria used to select these index funds is the five year return on NAV as of September 2008.  All the index funds listed below are exchange traded funds and are broken down into two categories - domestic and international index funds.

Best Performing Domestic Index Funds

Best Performing International Index Funds

About the Author - Buying an Index Fund

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2008 Money-Zine.com

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