How to Pick the Best Index Funds

Well-known investors, such as Warren Buffet, have often expressed their opinions about index funds. Most of them recommend that a portfolio should always consist of some index funds. Index funds are mutual funds that are designed to track the performance of the funds in the index they are mirroring. This means that the shares of stocks in the fund are taken from the companies that make up the index.

An example of an index is the S&P 500 (SPX). This index consists of large companies such as Microsoft, Apple, and Amazon. An index fund is made of shares from a majority of the companies listed on the index, if not all of them.

Many of the index funds offer low expenses and long-term growth while adding a sense of security for investors. If you are considering investing in an index fund, you should consider the benefits and understand how to find and compare them to meet your investing goals.

What Is an Index Fund?

An index, with regard to investing, is a statistical sampling of securities that represents a defined segment of the market. For example, the S&P 500 Index is a sampling of approximately 500 large-cap stocks (large-capitalization, or companies with a large market capitalization). But since an index is only a list of hand-picked stocks, you can't actually invest in it. This is what index funds are designed to accomplish.

An index fund is a fund that buys and holds most or all of the securities that are in the particular index the fund wants to track. This is how and why John Bogle started Vanguard. After noticing that many investors, including professional money managers, were not able to outperform the major market indices, especially in the long run, he decided to create the Vanguard 500 Index (VFINX), which mirrors the performance of the S&P 500. That fund is now closed to new investors but is available as Admiral Shares trading with the symbol VFIAX.

The Benefits of Index Funds

One of the key benefits of index funds is that they have much lower expenses than other managed funds. Managers are not required to research as intensely since the stocks that make up the fund are already researched and identified as top performers. Thus, there are low or even no commissions with index funds.

Reduced Expenses and Convenience

Low expense ratios are the primary attractive trait for index funds; however, there is another trait that investors gravitate toward. Index funds seek to track the benchmark index. It should then follow that the fund portfolio is structured to mirror the index the fund is tracking. This might seem complicated, but it isn't—the fund is made up of shares from the companies that make up the index.

Index funds are very convenient—they can be purchased at mutual fund companies or brokerages alike. Your bank may offer investment services, allowing you to use them as your broker when choosing an index fund.

The Lower Risk Boosts Confidence

Risk is quite possibly the number one reason many people shy away from investing. By choosing an index fund, new and experienced investors both can be confident in their choice—simply because these funds track the performance of well-vetted investments.

When you hear that the Dow Jones is up, and you have invested in an index that tracks the Dow Jones, you know your investments are increasing in value. You'll be able to invest, with one purchase, in a broad choice of markets—large-cap, small-cap, foreign, bonds, and others.

The other trait to look for in index funds is a low tracking error, which is a measure of an index fund's effectiveness in replicating or "matching" the performance of the benchmark index.

When you are looking over index funds, compare the performance of the fund with the index it is supposed to mirror. If it is not tracking the index with a tolerable percentage (based on your criteria), then you might consider skipping that fund.

Finding an Index

Most people have heard of the big three indexes in the U.S.—the Standard & Poor's 500, Dow Jones Industrial Average, and the Nasdaq Composite. However, there are many more indexes investors can choose from.

The Wilshire 5000 is an index generally accepted as the benchmark for the entire equity market (stocks). There are also the Dow Jones U.S. Small- and Large-Cap indexes, the MSCI USA Large-Cap Index, and many others to choose from.

While searching for an index fund, it's important to find one that mirrors your investing goals and investing budget. Some of the large-cap index funds require quite reasonable minimum investments. The Wilshire 5000 Index Fund (WFIVX) minimum initial investment is $1,000, while the Vanguard Large-Cap ETF (VV) requires no minimal investment through their brokerage services.

Some Final Thoughts

The market will fluctuate over long periods of time, with prices rising and falling like a wave. But the market has generally increased over time. As you are choosing the best index funds, look over the entire history of the fund. You'll more than likely see that these funds have exhibited similar behavior, as they are designed to track their designated market.

Think long-term when investing in index funds. With this and other considerations in mind, you'll be able to choose the best index funds for you and your investing goals.