A Comprehensive Guide To Index Funds

If you are not new to the stock market you must have heard of index funds. Every investor wants to allocate at least some portion of their portfolio to such a product that is comparatively less risky so that the overall portfolio risk is reduced. Index funds are one such financial product that is less risky and thus safe to invest in.

In this article, we will discuss what index funds are all about and why they are considered to be a safe investment option.

Here is what you will find in this article.

1. Meaning of Index Funds
2. How Do Index Funds Work?
3. How to Invest in Index Funds?
4. Are Index Funds Safe?
5. Why You Should Invest in Index Funds

Let’s begin!

Meaning of Index Funds

An index fund is a kind of mutual fund that mimics the performance of a specific market index. The fund does so by constructing a portfolio in the same manner and proportion as a market index such as the S&P 500. S&P 500 or the Standard & Poor 500 is a US-based stock market index that tracks the performance of the listed stocks of the top 500 companies. This means that if an index fund is based on S&P 500, then the fund will invest in all those stocks that form part of the S&P 500 index and the investment is done in each stock in the same weightage in which the value of that stock is contained in the index.

These funds are not being actively managed since they only replicate the index funds. Due to this reason, they are classified as “passive” funds. The administration expenses and fees incurred by these funds are lower than the actively managed funds such as mutual funds.

If index funds interest you and you are looking for a platform from where you can index funds then you can consider WealthSimple as they not only provide a platform for index funds investment but also make use of powerful financial tools to help you grow and manage your funds. With WealthSimple you can invest in an auto-pilot mode which means that the investment procedure gets automated for you.

How Do Index Funds Work?

The index funds manage their investments in the same proportion as the index that they are based on. Since they invest in the same stocks and in the same proportion as the index, the similar returns are earned by the fund. Thus, the fund managers instead of strategically choosing the stocks and managing their entry and exit, they develop a portfolio in the same manner as a market index. The index fund may entirely be based wholly or substantially on a market index.

The index funds follow the same weightage to invest in the securities as existing in the market index. The fund managers review the weightage of the securities in the fund periodically and carry out the transactions in the securities to match the weightage of the index. Thus, the change in the value of each unit of an index fund, known as NAV, is in line with the change in the value of the index. However, there can be minimal deviations in the actual returns as it is practically not possible to mirror the returns and portfolio of the index. The factors that lead to minor deviations in the returns are known as tracking errors.

How to Invest in Index Funds

Investing in index funds is pretty simple and involves three main steps.

Choose a Market Index

There are many options when it comes to indexes and you need to determine the index on which you want your index fund to be based. Some of the examples of indexes are S&P 500, Dow Jones Industrial Average (DJIA), MSCI EAFE, Russell 2000, and Barclays Capital U.S. Aggregate Bond Index. These indexes are different from each other in terms of market cap, the country in which securities belong, security type, and other similar factors. For example, the S&P 500 is a large-cap index and Russell 2000 is a small-cap index.

Your choice of the index can also be based on specific industries that are tied to the indexes. For example, if you are looking to invest in an index based on banking, then KBW Bank Index is one of the indexes that you can choose. It is a stock index based on the stocks of 24 most prominent banks in the U.S.

If you are not confident of making this selection it is better to take the help of an investment advisor such as WealthSimple as they help you to find the right index fund for you so that your returns are maximized. They help you reach your financial milestone by suggesting the right investment product.

Select the Index Fund

After you have decided upon the index it becomes easier to find the index funds that are based on the select index. There might be more options for index funds when the index fund is a popular one like the S&P 500. In such a scenario, you can consider the following factors for finalizing one index fund for your investment:

• Select a fund that has the lowest expense ratio as it would imply lower fund costs and thus, higher returns.
• Compare the index funds to analyze the returns of which fund is closest to the index. The fund which has the closest return as that of the fund shall be preferred.
• Check if there is any such condition for investment in the fund which seems inconvenient to you. Suppose an index fund requires you to invest a certain minimum amount of funds, then analyze whether you have enough funds for investing or you need to select some other fund.

Purchase the Units of Index Funds

Now that you have selected the index fund, it’s time to invest in the units of index funds. There are two ways in which you can start investing. You can either directly open your account with the company that offers the index fund or you can invest in the funds through a broker by maintaining an account with them.

When trading through a broker make sure that you choose a broker that charges you the lowest commission. That is why you can consider opening an account with WealthSimple. They provide you three different kinds of accounts and for all of the accounts fees charged is pretty low. Further apart from index funds they can also help to save for your future with the help of their IRA plans.

Are Index Funds Safe?

This is a very common question that pops up in the minds of investors. If you are wondering whether you can lose money in an index fund, then we would like to tell you that index funds are considered to be a safe investment option. This is because they are based on indexes that consist of top-performing securities and give similar results. Also, since the portfolio consists of diversified investments the quantum of losses is reduced in case one or two stocks in the index underperform. This also means that the returns of the index funds can only be in line with that of the index and the index funds can’t outperform the index itself. Thus, we can say that the index funds are as safe as the index on which it is based. It is therefore important to go for such index funds that are based on popular and good performing indexes such as S&P 500 as they are comparatively safer.

Investment advisors like WealthSimple can advise you about which index funds are better for you and how you can diversify your portfolio with other safer options.

Why You Should Invest in Index Funds

If you are still confused about whether index funds can be the right investment choice we are presenting some reasons why investors consider parking their money in index funds.

• The index funds are less costly because they are passively managed and thus related administration costs are lower than mutual funds or other actively managed funds.
• The risk involved in index funds is generally lower as they are based on indexes and therefore, yield similar returns. This is one of the main reasons why investors go for index funds. The funds are ideal for those who are planning their retirement as the value of the funds grows over the years with the stock market.
• It is an easy investment option since you need not pick up individual stocks for investments. The funds are managed by the fund managers who are professionals, and thus, you can place your reliance on the portfolio chosen by them.
• The transaction costs involved in index funds are low because the portfolio of these funds doesn’t change unless the index changes itself. And, the changes in the index are not frequent. Since the costs are lower the returns are maximized.

Index funds are a good investment option but being a wise investor you should always diversify your investments which means that apart from index funds you must add other investments to your portfolio so that the portfolio is diversified and the risk of loss is reduced. After all, diversification is a must when it comes to portfolio management.