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How to invest in index funds

The ins and outs of bundling stocks with this accessible investing option.

What is an index fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds the same assets that are part of a market index, such as the S&P 500. Because of that, the price of the index fund moves the same as the market index.

3 steps to invest in index funds

Investing in ETF index funds is as simple as buying any other stock on the stock market. Here’s how it works:

1. Pick an index

An index fund tracks a market index, such as the S&P 500 or Nasdaq. These funds are made out of multiple stocks or other assets. That’s why the index fund performs similarly to the market index it tracks.

There are thousands of indexes to choose from, including those that track large companies, small companies, foreign companies, commodities like gold and silver and more. The most popular ones are:

  • S&P 500. This index tracks the 500 largest companies listed on US exchanges. Some of the most popular companies in this index include Amazon, American Express, Berkshire Hathaway, Google and FedEx.
  • Russel 2000. This index tracks the smallest 2,000 companies in the Russell 3000 Index. This includes companies like 3D Systems Corp, AMC Entertainment, Evofem Biosciences and Novavax.
  • Nasdaq Composite. This stock market index includes almost every stock listed on the Nasdaq stock exchange. It mostly includes companies in the information technology sector, such as Apple, eBay, Intel and Google.

2. Pick a fund for the index

Depending on which index you want to invest in, there could be multiple ETFs tracking it. For example, more than 15 ETFs track the S&P 500. The performance of all these ETFs is virtually the same; the difference is which company owns the index — whether it’s Vanguard, MSCI, iShares, Invesco or others.

Additional aspects to consider before you choose a fund are:

  • Expense ratio. This is the ETF’s annual fee. Luckily, it’s relatively low — typically less than 1% for popular funds — and rarely goes above 2% annually.
  • Leverage. Some ETFs are 2x or 3x leveraged. This means the fund will move two to three times as much as the index would move in either direction. Leveraged funds come with a lot of risk attached, so they’re not for beginner investors or for those with a low risk tolerance.
  • Long or short. Long ETFs rise if the index rises and fall if the index falls. Short ETFs move inversely — your investment rises if the index drops and vice versa.

3. Buy the index fund

Here’s how to buy an index fund from a brokerage account:

  1. Sign up and log in to your account.
  2. Search the fund’s ticker symbol or look for the fund manually.
  3. Enter the number of shares you want to buy and at what price.
  4. Review your order and submit.

Benefits of investing in index funds

  • Diversification. By holding an index ETF, you have exposure to multiple companies or assets.
  • Cost. An index fund could hold hundreds of companies. By owning shares of the fund, you indirectly invest in all these companies. If you want to invest in the same companies individually, you would have to make hundreds of transactions and potentially pay transaction fees.
  • Easy to trade. You can buy or sell ETF funds whenever you want during market hours and as easily as you would trade any individual stock.

Risks of investing in index funds

  • Losses. Like any investment, you take the bad with the good. When an index drops, so does your investment.
  • Tracking error. This could cause the ETF price and the market index to slightly differ. Add in the ETF’s annual fee and you could be looking at a worse performance than the market index it was supposed to match. Luckily, this rarely happens with popular index funds.

Are index funds good for beginners?

Yes. ETFs are one of the most beginner-friendly assets you can get. The fund buys shares from all the companies the market index tracks, and all you have to do is buy the fund’s shares.

If the fund holds dividend stocks, you’ll get dividend payments each quarter. If a company is delisted or listed in the index, the fund will adapt its portfolio accordingly.

The three popular index funds you can invest in are:

  1. Vanguard S&P 500 ETF (VOO). This fund tracks the S&P 500. It holds $789 billion of assets under management and costs 0.03% annually, or $0.3 for every $1,000 invested.
  2. Vanguard High Dividend Yield ETF (VYM). VYM tracks the FTSE® High Dividend Yield Index. It holds $64 billion in assets and costs 0.06% annually, or $0.6 for every $1,000 invested.
  3. Vanguard Total World Stock ETF (VT). This ETF tracks the FTSE Global All Cap Index. It holds $34 billion of assets and costs 0.08% annually or $0.8 for every $1,000 invested.

Investing in index ETF funds vs. mutual funds

Most ETFs are similar to traditional index mutual funds in that they are low-cost and track a major underlying index, though there are several key differences:

Trade and listingPricingWhen to buy and sellMinimum investmentFees
ETFsTraded like shares on the stock exchangeMarket value, depends on stock market performanceAny time during the trading dayLower minimum — sometimes under $100
  • Commission on some brokerages
  • Lower taxation and management fees
Mutual fundsUnlisted and bought from issuerNet asset value of underlying securities.At the end of the trading dayCan require as much as $2,500
  • No transaction fees
  • Some charge load fees

Bottom line

  • Index funds are well-diversified, accessible investments, making them a popular choice for all types of investors.
  • But there are also riskier and more complex index funds you can buy.
  • To invest in index funds you have to pick an index, then choose a fund that tracks the index and finally buy shares of the index fund you want.

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