At first glance, it may appear intimidating to understand how to choose an index fund the right way. Especially for a beginner…
And that’s totally justifiable. After all, it is more than likely that you will only select your index fund once.
But I assure you, it isn’t rocket science. It’s not like you will have to pick stocks on your own or anything.
In this article, I am going to basically take you by the hand and walk you through a simple 4-step process to identify the right index fund for you!
Ready to roll? Let’s get to it then…
1. Type of Investment
First things first, make up your mind about the type of investment you want to go with.
The two most basic types of investments people choose here are stocks and bonds.
To put things into perspective, keep in mind that stocks are a generally more risky security to put your money in compared to bonds.
Stocks will be for the folks who want to ensure that they have access to the probability they will substantially increase their wealth over time.
Bonds are not supposed to do that. They are for those who want a steady stream of income (interest) and are more risk-averse.
So, before you move on, take a moment to think exactly what it is that you want.
2. Type of Index
Next comes the type of index your index fund will be following.
There are 3 main types of indices that we will be looking at here:
- Sector-based,
- Broad-market, and
- international-market indices.
Let’s take a look and see what’s best for you.
Sector-Based Index
Sector-based indices are simply those that are supposed to represent a specific sector.
Take for example the energy sector. If you want to invest in energy stocks, instead of picking them on your own, you simply put your money into an energy index fund.
Broad-Market Index
Now, a broad-market index is one that represents the broad market. This is what most people go with.
If you don’t love the idea of focusing on a specific section of the market, then the next logical solution is to invest in the market as a whole.
Just keep in mind that you also need to define how big you go here…
There are indices that represent the market with 500 or 3000 stocks (take as examples the S&P 500 and Russell 3000, respectively). But there are also broad-market indices that only include 30 stocks like the DJIA.
So, take this into account when you choose your broad-market index fund.
International-Market Index
And of course, you can also go really broad! As in… internationally broad!
If you want to be even more diversified than those who go with classic broad-market index funds, then you need an international-market index fund like the Fidelity International Index Fund or the Schwab International Index Fund.
That can be overkill though if you’re young and can afford to take the risk that broad-market index funds carry. So, think carefully…
3. Expenses
Most people when they try to figure out how to choose an index fund, they think about expenses…
After you have chosen the type of investment and index you want to go with, you must carefully analyze the various expenses that investing in an index fund entails.
First, compare the expense ratios between the index funds that you are interested in. The expense ratio is basically the fee that the fund managers charge you and it is simply a percentage of the money you invest.
These are generally low for index funds (between 0.02% to 0.2%) but it never hurts to go for the lowest. These costs can account for much more in the future.
Besides that, you also need to pay attention to the load index funds charge. The load is a cost for buying the index fund or exiting it.
There are two types of loads.
The first is the front-end load which is the commission that the intermediary who sells you the index fund gets for their work to select an appropriate fund for you.
The other is called the back-end load and it’s basically a fee you will have to pay to exit the index fund. This can be either a flat fee or decrease over time until it drops to zero.
It’s either-or, of course. You will have to pick your poison. Although, there are the so-called no-load index funds that charge none. But you should be aware that these may have higher expense ratios.
4. Performance
The last thing you should check before you bite the bullet is how well the index fund has been performing.
First, take a look at the historical performance of the index fund during the number of years that you want to hold your investment for. Then, decide to see if the average annual return seems satisfactory for your needs.
Next, take a look at the tracking error, which is the deviation of the index fund’s return from the respective index’s return.
For example, if an index fund has returned an 8% in profit in a given year and the index that it follows was up 10%, the tracking error was -2% for that year.
The tracking error isn’t as important as the historical performance over a time-frame, of course. But it is an indication of whether the fund managers have been doing their job well or not. In other words, it pays to look at the index fund that has the smallest tracking error.
Recap
And that’s how to choose an index fund! It’s not hard after all, right? It certainly beats reading through financial reports.
To recap, before you select an index fund you should:
- Choose the type of investment you want to go with; stocks or bonds,
- Pick the type of index you want your fund to track (sector-based, broad-market, international-market ),
- Check the basic expenses you will have to suffer to invest in the index fund (expense ratio and load), and
- Study the performance of the index fund over the time-frame you will keep being invested in and the tracking error.
I hope this article helped you understand how to choose an index fund without feeling you don’t know what you’re doing. If you found it helpful, could you please share it through social media?
Also, make sure you leave a comment below to let me know what type of index fund you are considering going with!
Thank you for reading…
Disclaimer: This information should not be viewed as financial advice. You should consult a financial advisor or do your own due diligence before you invest. The owner of this website and author of this article are not to be held liable for any undesired result by anyone who uses this information that is provided here in any way.
