How to invest like a pro with index funds


Lucky you, if you’re in an index fund. The best-known market benchmarks, the Dow Jones industrial average and the S&P 500, have been soaring to record highs, taking index-fund investors along for the ride.

Investing is a straightforward process once you understand that index funds are a smart option for your portfolio.

Index funds are mutual funds or exchange-traded funds that track an index, such as the S&P 500. They are designed to give investors exposure to a broad swath of the stock market at a very low cost.

Index funds are distinct from actively managed funds. An active fund and an index fund may hold some of the same companies. But the active fund will hold them in different weightings and concentrations in an attempt to beat the index, which leads to a vastly different set of risks and returns.

Index funds consistently outperform most active funds, and they do it with lower fees.

What’s an index?

An index is a set of companies that represents some segment of the stock market or even the entire stock market. The Standard & Poor’s 500 — S&P 500 for short — tracks 500 large companies and is the nemesis of active managers who try to beat it.

The Wilshire 5000 is broader, and is designed to measure the performance of all stocks actively traded in the U.S. And then there’s the Russell 2000, which measures the ups and downs of small-cap companies.

There are indexes for every sector of the market throughout the world — hundreds of them.

“A good way to think about it is like a funnel. You could think about it in terms of the broadest of the broad markets, and then imagine it narrowing to focus on specific types of companies,” says Jim Rowley, head of active-passive portfolio research at Vanguard.

Investors can choose a single fund that tracks the world stock market or build their own template with index funds of individual countries or regions.

There are other ways to slice the pie that is the stock market. There are indexes that track companies according to size — large, medium or small — and indexes that follow one particular sector or industry, such as health care or technology.

Here’s another wrinkle: Bond indexes split up the bond market in similar ways. Rather than segmenting bonds by the size of the company, they are grouped according to the creditworthiness of the company, because bonds are a debt instrument. They’re also categorized by the bonds’ maturity. For instance, short-term bonds are in one basket, while long-term bonds are in another.

Wait, that sounds complicated

The myriad options can be overwhelming, but don’t give up.

“One of the great things about index funds is that they are a great starting point,” Vanguard’s Rowley says. Vanguard was founded by John Bogle, the inventor of the index fund.

“If you want to build a broadly diversified, low-cost portfolio, a smart way is to choose a U.S. market index fund, an international market fund and investment-grade bonds,” he says.

Consider this example: Vanguard’s Total Stock Market Index Fund includes about 3,600 stocks. Its Total International Stock Index Fund is made up of companies in emerging markets and developed countries, excluding the U.S. It consists of 6,270 stocks.

Two funds, nearly 10,000 stocks, plus one high-quality bond fund. And just like that, you’re investing like a pro.

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