Safe Investing using Index Funds requires you to know one thing...

Index funds are gaining popularity as more and more people enter the market looking for a low maintenance way to make money.

Since market indexes are widely recognized and used as the basis for most performance numbers, financial service companies started offering funds that try to copy the performance of an index with very low cost and risk (for themselves).

What are Index Funds

These funds are financial assets that are created to mimic the performance of market "averages".

They offer a low cost way for an individual investor to practice index investing.

Why buy Index Funds

Investors looking to add a large variety of investments to their portfolio, without having to buy single units of each one, are the target audience for this type of fund.

For example, assume you want to buy a share of every company within the S&P500.

First, you'll need a lot of capital. And for each purchase, you'll be charged a commission.

If you paid $7.99 per trade for commission, your personal S&P500 index would cost you $3,995 in commissions alone!

Or, just buy shares in an S&P500 index fund, and get the same relative performance for ~$8.

The One Thing You Need to Know

Usually, the financial service company buys all of the financial instruments or securities of a specific index. So a fund modeled after the S&P500 will typically contain all of the stocks that are part of the S&P500.

While there are lots of factors than can affect performance, the fund will generally underperform the index it follows by a known amount: the expense ratio!

Therefore, the expense ratio is recognized as the most important factor for choosing between similar funds.

Factors that Affect Price

  • Price movement of the actual indexes
  • Changes to the assets in the index (such as re-balancing)
  • Costs, fees, and management overhead for the fund
  • Leverage

Investing Choices

There are several ways to group these funds.

An easy way is to arrange all the choices by the creator of the fund.

Basing your decisions on the investment firm is a great way to select options based on reputation/management practices.

But it does not tell you what types of assets are in the fund (i.e. what is being bought and sold).

It is in the best interest of each financial services firm to offer as many funds as possible. This does not mean that every fund offered is a good buy.

Check how long the fund manager has managed the fund. This will let you know who is responsible for fund performance (both good AND bad).

So the next natural grouping is by the type of assets:

If you're thinking of using a leveraged and/or inverse fund, BE CAREFUL. You are buying a fund that tries to match the percent increase or decrease each day (verses the price movement from the previous days close).

Matching a daily percentage move creates a compounding problem (see our compound interest example for more info ). So you are not purchasing a fund that matches the performance of an "unleveraged" fund over a long period of time.

Where to buy Index Funds

When checking out the different financial services companies, choose one with a good reputation. Fidelity and Vanguard are the best known, while ProShares, iShares, and Rydex are relatively new players.

You can buy these funds using any of your investing accounts.

If you don't have one, you will need to open a trading account with an investment broker.