Index Funds: Is Cheaper Always Better?

Index funds are a type of investment fund that tracks a specific collection of assets called an index. The index can include stocks, bonds, and other assets. They are a passive investment, meaning they aim to match the performance of the index rather than actively investing in the market. This makes them a low-cost way to invest in a diverse range of assets.

When deciding whether to invest in low-cost or expensive index funds, it is important to consider the fees involved, the level of diversification offered, and the potential returns. Low-cost index funds typically have lower expense ratios because they are passively managed, while expensive index funds may offer access to more specialised or niche assets. It is also important to remember that past performance does not guarantee future results, and it is always recommended to consult a financial professional before making any investment decisions.

Low-cost index funds vs. ETFs vs. mutual funds

Low-cost index funds are a great way for both new and advanced investors to enter the stock market. They can reduce risk compared to investing in individual stocks and are a good choice for those looking to minimise the time and money spent investing.

Index funds can be bought and sold as either an exchange-traded fund (ETF) or a mutual fund. ETFs are more flexible and highly liquid, allowing investors to enter or exit a position whenever the market is open. They are also more tax-efficient than mutual funds. ETFs can be traded like stocks, so they are accessible with a basic brokerage account.

Mutual funds, on the other hand, are less flexible and less liquid than ETFs. They are bought and sold directly from the mutual fund company at the net asset value (NAV) price, which is calculated at the end of each trading day. Mutual funds are ideal for buy-and-hold investors as they can be purchased through an investor's bank.

Both ETFs and mutual funds are overseen by professional portfolio managers and are less risky than investing in individual stocks or bonds. They both offer a wide variety of investment options, giving investors access to a diverse range of US and international stocks and bonds.

When deciding between ETFs and mutual funds, investors should consider their investment goals, risk tolerance, and financial situation.

The pros of low-cost index funds

Low-cost index funds have several advantages for investors. Here are some of the pros:

Lower Costs and Higher Returns

Low-cost index funds have lower expense ratios because they are passively managed. The money that would be lost to fees compounds in your investment account, and investors who focus on minimising costs can generate superior returns over time.

Broad Market Exposure and Diversification

Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is ideal for investors seeking a diversified investment that tracks overall market trends.

Transparency

The holdings of an index fund are well-known and easily accessible on investing platforms, providing transparency for investors.

Historical Performance

Over the long term, many index funds have outperformed actively managed funds, especially after accounting for fees and expenses.

Tax Efficiency

Index funds have lower turnover rates, resulting in fewer capital gains distributions, making them more tax-efficient than actively managed funds.

Simplicity and Accessibility

Index funds are a simple, cost-effective way to gain exposure to a broad, diversified portfolio. They are also easily accessible to investors with minimal investment research, as the fund's portfolio manager simply matches the underlying index's performance.

The cons of low-cost index funds

While low-cost index funds are a popular investment strategy, they do have some drawbacks. Here are some of the cons of investing in low-cost index funds:

• Lack of Downside Protection: The stock market has its ups and downs, and while investing in an index fund can give you the upside when the market is doing well, it also leaves you vulnerable to losses when the market declines. During prolonged downturns, these funds can perform poorly, in line with the broader market.
• Lack of Reactive Ability: Index funds do not allow for advantageous behaviour. If a stock becomes overvalued, it carries more weight in the index, but this is when investors would typically want to lower their exposure to that stock. With index funds, you cannot act on this knowledge.
• No Control Over Holdings: Index funds are set portfolios, and investors have no control over the individual holdings. You may want to invest in specific companies that you like or believe in, but with index funds, you are limited to the companies included in the index.
• Limited Exposure to Different Strategies: There are many successful investing strategies, but index funds may not give you access to them. Index funds provide diversification, but this can also be achieved with a smaller number of carefully chosen stocks. With index funds, you may miss out on the best value stocks or growth stocks identified through other strategies.
• Dampened Personal Satisfaction: Investing can be stressful, and index funds may not alleviate this stress. You may still find yourself constantly checking the market's performance and worrying about the economic landscape, without the satisfaction of making individual investment decisions.
• Lack of Flexibility: Index funds are designed to mirror a specific market, so they decline in value when the market does. They cannot pivot or adjust their strategy when the market shifts.
• Inability to Duplicate Top Fund Managers: While index funds are often recommended by experts, they do not allow investors to duplicate the approaches of the most successful fund managers. Certain strategies, such as growth at a reasonable price (GARP), may be difficult to implement with index funds.
• Market-Cap Weighting: Many index funds use market-cap weighting, which means companies with higher market capitalizations have a more significant influence on the fund's performance. This can lead to a concentration of risk in a few large companies.

How to choose a low-cost index fund

Index funds are a type of mutual or exchange-traded fund (ETF) that tracks the performance of a market index, such as the S&P 500, by holding the same stocks or bonds or a representative sample of them. They are a passive investment, meaning they aim to match the performance of an index without actively investing in the market. Here are some steps to help you choose a low-cost index fund:

• Research and analyse: Consider the geographic location of the investments, the market sector, and the market opportunity. You'll also want to examine what the fund is investing in, so you know exactly what you're getting into.
• Check the fund's expenses: Compare the expenses of each fund you're considering. Sometimes a fund based on a similar index can charge much more than another. Look for funds with low expense ratios, as these will result in higher returns on your investments.
• Consider taxes and investment minimums: Mutual funds tend to be less tax-efficient than ETFs, and they often have minimum investment amounts. ETFs, on the other hand, usually have lower investment minimums and don't have taxable capital gains distributions like mutual funds do.
• Purchase the fund: You can buy the fund directly from the fund company or through a broker. If you're buying an ETF, you'll need to go through a broker.
• Vanguard 500 Index Fund Admiral Shares (VFIAX): Tracks the S&P 500 with a 0.04% expense ratio and a $3,000 minimum investment.
• IShares Core S&P 500 ETF (IVV): Tracks the S&P 500 with a 0.04% expense ratio.
• Fidelity ZERO Large Cap Index (FNILX): Tracks the Fidelity U.S. Large Cap Index with a 0% expense ratio.
• Vanguard Total Stock Market ETF (VTI): Tracks a broad market index with a 0.03% expense ratio and no minimum investment requirement.
• BNY Mellon U.S. Large Cap Core Equity ETF (BKLC): Tracks the Solactive GBS United States 500 Index with a 0% expense ratio.

How to invest in low-cost index funds

Index funds are a passive investment strategy that tracks the performance of a market index, such as the S&P 500. They are a low-cost, easy way to build wealth over the long term and are popular with retirement investors. Here is a step-by-step guide on how to invest in low-cost index funds:

Understand Index Funds

First, it is important to understand what index funds are and how they work. Index funds are a type of investment fund that tracks a specific collection of assets called an index, which can include stocks, bonds, and other assets. The fund does not actively invest in the market but tries to match the performance of the index by holding the same assets in the same proportions. Index funds are passively managed, which means they do not actively pick securities or time the market. They are a long-term investment strategy and are suitable for both beginner and advanced investors.

Choose an Index

There are many different indexes that you can track using index funds. The most popular index is the S&P 500, which includes 500 of the largest publicly traded American companies. Other popular indexes include the Dow Jones Industrial Average, the Nasdaq Composite, the Russell 2000, and the Russell 3000. You can also find indexes that focus on specific sectors, industries, or international stocks. Choose an index that aligns with your investment objectives and goals.

Research and Select an Index Fund

Once you have chosen an index, you need to research and select a specific index fund to invest in. Look at the fund's performance history, management fees, and the index it tracks. Compare different funds to find the one that best fits your needs and has the lowest costs. Remember that the key differentiator between index funds tracking the same index is the cost, so look for funds with low expense ratios.

Decide on a Brokerage or Fund Provider

You can purchase index funds directly from a mutual fund company, a brokerage, or a robo-advisor. If you want to hold all your investments in one place, consider opening a brokerage account. Some brokers charge extra for buying index fund shares, so compare costs before deciding. Also, consider the fund selection, convenience, trading costs, and commission-free options when choosing a provider.

Buy Shares of the Index Fund

Once you have chosen a provider and opened an account, you can purchase shares of the index fund. You may be able to select a fixed dollar amount to invest or choose a number of shares based on the share price and your budget. Remember that index funds are typically long-term investments, so you should be prepared to hold them for the long term.

Monitor and Adjust Your Investments

While index funds are passive investments, it is still important to periodically review and adjust your portfolio to ensure it aligns with your financial goals. Check that your index fund is performing as expected and that the fees are not stacking up over time. Remember that index funds are subject to market swings, so don't panic if the returns don't exactly match the index's performance.

Frequently asked questions