The argument in favor of low-cost index funds is simple: Active funds cost more and are less likely to live up to their promises.
According to S&P Dow Jones Indices Risk-Adjusted SPIVA Scorecard: Year-End 2020, after adjusting for volatility, the majority of actively managed domestic funds across market-cap segments underperformed their benchmarks on a net-of-fees basis over mid- and long-term investment horizons.
If you're looking for a straightforward, inexpensive investing strategy, you need to know about low-cost index funds. Here are a few points to keep in mind:
-- What is an index fund?
-- What are the different indexes to choose from?
-- How to invest in low-cost index funds.
-- The lowest-cost index funds on the market.
-- Low-cost index mutual funds versus exchange-traded funds.
-- Things to consider if buying an index fund.
What Is an Index Fund?
To understand index funds, you first need to understand the difference between a stock market index (like the S&P 500) and an index fund, such as the SPDR S&P 500 ETF Trust (ticker: SPY).
A stock market index is a curated selection of stocks designed to represent the broader market. Index providers like S&P Dow Jones Indices created indexes to make it easier to gauge overall stock market performance rather than clicking through the latest price data on every stock.
Each index reflects a slightly different perspective of the market. For instance, the Dow Jones Industrial Average -- composed of 30 significant stocks trading on the New York Stock Exchange -- was designed to represent the broader U.S. economy, while the S&P 500 tracks the 500 largest publicly traded U.S. companies.
Once an index is defined, it remains static until the index provider changes the components, says Andrew Crowell, vice chairman of D.A. Davidson & Co.'s wealth management division in Los Angeles. Most stock market indexes are rebalanced once per year.
Indexes are used for tracking purposes only. You can't invest directly in an index. Instead, index investors buy low-cost index funds that track their chosen index.
Index providers like S&P Dow Jones don't sell index funds. They create the index, and other entities, like Vanguard and Fidelity, create index funds to track those indexes.
What Are the Different Indexes to Choose From?
Index fund managers mirror the investments held in their benchmark index with the goal of matching that index's performance by buying a similar number of shares at the same ratio. For example, if the benchmark has twice as many holdings of Apple ( AAPL) to Alphabet ( GOOG, GOOGL), the manager will buy two shares of Apple for every one share of Alphabet in the fund.
Since the manager isn't actively analyzing and selecting which investments to hold, index funds are considered passively managed funds that follow major indexes as their benchmark. These include:
Dow Jones Industrial Average (DJIA). This price-weighted index is one of the oldest U.S. market indices which measures the performance of the 30 largest publicly traded blue-chip stocks in the U.S., including Apple, Disney ( DIS), Microsoft ( MSFT) and Walmart ( WMT). The DJIA covers companies in all industries minus transportation and utilities.
S&P 500. The S&P 500 follows the performance of 500 of the largest U.S. companies and is considered a benchmark for the performance of the overall stock market. Many invest in funds that track the S&P 500 as their benchmark because the index represents leading U.S. companies in their respective industries. The S&P 500 is market cap-weighted, meaning that the larger the company the more it's represented in the index.
Nasdaq Composite. The Nasdaq is the first global electronic exchange that holds more than 3,300 companies, which are traded on the index. For this reason, many all-star technology companies choose to be listed on this particular index. Similar to the S&P 500, many investors choose to invest in low-cost index funds that track the Nasdaq, namely to gain exposure to big tech companies.
Many other indexes represent different areas of the stock market -- such as the Russell 2000 index, which tracks the 2,000 smallest publicly traded companies, or international exchanges like the FTSE 100 that represents 100 of the largest companies on the London Stock Exchange and the Nikkei 225, the major index for Tokyo's Stock Exchange, which tracks the performance of top companies in Japan.
Minimal legwork on the part of the manager is why expense ratios for index funds are so low. Investors can buy low-cost index funds for pennies on the dollar, or nothing at all.
How to Invest In Low-Cost Index Funds
"The good news and bad news for investors is there are literally thousands of index funds," Crowell says. This can make it a challenge to find the best low-cost index fund for you.
Here's how to choose a suitable low-cost index fund:
-- Determine your desired exposure.
-- Choose the right index to track.
-- Evaluate total cost, including expense ratios and trading fees.
-- Look for a low tracking error.
-- Consider the fund manager's experience as well as the index provider.
"The starting point for any investment is a comprehensive financial plan," he says. Your plan will inform your desired asset allocation and the type of index fund you should use.
"The more risk-averse or nervous the investor, the broader the stock market index they should use," as broader indexes provide a "smoother ride," he adds. For example, if you're hesitant about investing, you might opt for a total stock market index as opposed to a small-cap index.
Once you know the type of low-cost index fund you want, you can begin shopping. An easy place to start is the expense ratio. A good expense ratio for a low-cost index fund is about less than 0.2%.
But the expense ratio is only one component of an investment's cost. Also, beware of trading fees (more common with ETFs) and mutual fund sales loads.
A sales load is a commission a mutual fund pays for brokers to offer the fund to their investors. The cost of this sales load is deducted from your investment either when you buy (a front-end sales load) or sell (a back-end sales load).
Then there's the tracking error. This measures how closely the index fund tracks its underlying benchmark. The lower the tracking error, the closer the fund's returns match its benchmark.
"Active portfolio managers typically show a large tracking error because they seek excess return (alpha) through their active positioning versus the benchmark," says Karissa McDonough, chief fixed income strategist at People's United Advisors in Vermont.
A consistently low tracking error is a sign of a good index fund manager.
"If an investor wants a fund that essentially mirrors the index without any active management, then they should focus on funds or ETFs that have annualized tracking errors close to zero," McDonough says.
Lastly, pay extra attention to self-indexed funds. These are index funds for which the fund provider has created its own index to serve as the benchmark. For example, instead of tracking the S&P 500, the Fidelity Zero Large Cap Index Fund ( FNILX) tracks the Fidelity U.S. Large Cap Index.
This can be a cost-saving strategy for fund managers because it lets them avoid having to pay a replication fee to third-party index providers for the right to replicate an index. But it also opens the door to less reliable indexing.
If your index fund is self-indexed, make sure you understand how the benchmark index is calculated. A low-cost index fund is only as good as the index it tracks.
The Lowest-Cost Index Funds on the Market
Here are the lowest-cost index funds from some of the largest index fund providers:
Fidelity ZERO Total Market Index Fund (FZROX)
Fidelity ZERO Large Cap Index (FNILX)
Fidelity ZERO Extended Market Index (FZIPX)
Fidelity ZERO International Index (FZILX)
Schwab S&P 500 Index Fund (SWPPX)
Schwab Total Stock Market Index Fund (SWTSX)
Schwab U.S. Broad Market ETF (SCHB)
Schwab U.S. Large-Cap ETF (SCHX)
iShares Core S&P Total U.S. Stock Market ETF (ITOT)
iShares Core S&P 500 ETF (IVV)
Vanguard S&P 500 ETF (VOO)
Vanguard Total Stock Market ETF (VTI)
Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Low-Cost Index Mutual Funds vs. ETFs
Index funds can come in two forms: mutual funds and ETFs.
Mutual funds were the first low-cost index funds and remain the lowest-cost index funds, but ETF index funds are increasingly popular for their transparency and liquidity.
Unlike mutual funds, which are priced once per day at market close, ETFs trade throughout the day like stocks. As such, investors can buy and sell their index funds at any time during the trading day. They also have a good idea of the price they'll pay or receive.
Alex Gordon, director of ETF sales at ETF Managers Group, a thematic ETF provider, says ETFs have multiple advantages over mutual funds, namely better taxation. "ETFs are able to limit capital gains distributions (in most cases to zero) while that is a consistent problem for mutual funds," he says.
"With the capital gains tax rate potentially changing, that could put an even bigger emphasis on favoring ETFs to make up a portfolio," Gordon explains.
The disadvantage to ETF index funds is that they can be trading above or below their net asset value, Crowell says. Index fund investors "can be assured of getting the true cost when buying an index mutual fund" because they're always priced at NAV, whereas you could be paying a premium or discount with an index ETF.
Things to Consider if Buying an Index Fund
Diversification. Index funds allow you to automatically diversify your investments. Owning one or more index funds of different asset classes helps manage your risk exposure.
Gordon says diversification is one of the key benefits of ETFs that offer "easy and liquid access" to the market. "Investors get the benefit of buying and selling into hundreds of stocks or bonds within one ticker," he says.
However, you want to avoid too much diversification to prevent overlap or a potential drag in performance.
Accessibility. Index funds are an investment vehicle that offers a way for all investors to easily and efficiently access different securities and asset classes. If you are new to investing and are taking a long-term, passive investment approach, investing through index funds is one of the simplest ways to get started.
Benchmark. Index funds can be a great investing tool, but like any vehicle, investors need to know what they own.
Consider the benchmark you want your investments to follow. Become familiar with different benchmarks to have a general understanding of how index funds will perform. An index fund that follows a particular index allows you to review the benchmark's composition, individual holdings, historical performance and other key factors that can help determine which investments fit best with your portfolio's strategy.