An index is an imaginary portfolio of stocks representing a segment of an industry or the entire economy. An index that aims to provide an accurate picture of a national economy comprises representative securities. The price evolution of these securities, seen as a whole, describes the evolution of the entire economy. The FTSE 100 is such an index in the UK.
You can only invest in an index indirectly through an index fund or an ETF. Index funds invest in the securities that make up an index, looking to track its evolution as closely as possible.
Investors can also make index-based investments through self-indexing and various index derivatives.
How Can You Invest in an Index Fund?
Investing in an index fund is a four-step process.
- Picking an index that makes sense as the underlying investment vehicle
- Selecting an index fund that tracks the index closely enough to make it relevant
- Deciding where to buy the index fund
- Committing and buying the shares of the fund
Picking Your Index
Investors seek certain types of exposure for their investments. Diversification is important, but having a clear understanding of the investment expectations is also important.
To know what to expect from their investment and what economic, political, and other fundamental factors will shape its evolution, investors must know the following:
- The size and capitalization of the index constituents
- The geographical location of the index constituents
- The industries and business sectors of the index constituents
- The type of the underlying asset
- The opportunities that the index’s underlying market harbors
Most investors know whether they want to invest in large-cap tech stocks or small-cap health-related stocks, and make their choices accordingly.
Although many index funds may seem attractive, the average investor only needs to invest in one to achieve adequate diversification. Index funds offer diversification by default, considering the diversity of their constituents.
Selecting an Index Fund
Many index funds track similar selections of indexes and underlying assets. The difference between them comes down to costs.
Being cheap investment vehicles is one of the main selling points of index funds. Not all of them are cheap, however.
Administrative fees make up most of the costs of index fund investing. Small differences in this respect can add up, inflating costs significantly.
A rule of thumb is that larger index mutual funds are cheaper.
Where to Buy the Index Fund?
To decide where to buy an index fund, investors should consider the following:
- The trading costs. Mutual fund commissions amount to more than stock trading commissions.
- Convenience. Small investors are more likely to value the convenience of a single provider. Sophisticated investors may appreciate the research and screening advantages a discount broker offers.
- Impact. Some index mutual funds allow investors to engage in impact investing, supporting various social and environmental causes.
- Fund selection and commission-free options.
To buy shares in mutual index funds, investors must open an investment account with a broker. A Roth IRA or a traditional brokerage account will work. Two variables determine how much you can invest in the index fund of your choice: the amount of money you’re investing and the share price.
Before investing in an index fund, investors should consider the possibility that individual stocks may represent a better investment option. Those who can’t afford to buy shares of an index fund directly may want to buy a smaller slice through an ETF.
The Advantages of Investing in Index Funds
Investing in index funds is a simple, no-nonsense way of building wealth. This type of investment offers many advantages.
- By investing in an index fund, investors secure the services of the fund’s portfolio manager. They don’t have to research stocks individually.
- By their nature, index funds feature diversified portfolios. Diversification reduces the risk for investors.
- Index funds are affordable alternatives to actively managed funds.
- Index funds give investors tax advantages.
- Index funds cover a wide range of financial instruments. They allow investors to cast a wide net diversification-wise or focus on certain segments of the financial markets.
As an index fund investor, you will never beat the market, however. Through such an investment, investors can only hope to match the performance of the market but not exceed it.
By investing in an index fund they like, investors may not gain exposure to individual stocks they like.