Index funds hold stocks, bonds or commodity positions to approximate the performance of an index. For example, a stock index fund might approximate the performance of the Standard&Poor’s 500 Index. An index fund approximates index performance by constructing the portfolio with many or all of the securities represented in the index and with approximately the same security allocations as the index.
Investing in an index fund starts with a decision to participate in the performance of one or more indexes. Some indexes capture broad categories, like non-U.S. stocks represented by the MSCI EAFE Index. Other indexes achieve more focus by targeting properties such as industries, market capitalization, individual countries, bond quality levels or certain bond maturities. The investor’s risk tolerance, return expectations, time horizon, personal preferences and how certain index exposure would complement existing investments generally govern the index decision.
The second step requires a decision about which index fund form is more suitable: open-end funds or exchange-traded funds (ETFs). When an investor uses an open-end fund, the transaction is between the investor and the sponsoring investment company. ETF transactions, however, only occur on a stock exchange and the sponsoring investment company is not generally involved.
Different open-end funds and ETFs designed to approximate performance of the same index generally yield similar performance before fees and expenses. Therefore, fees and expenses represent an important decision factor. Fees and expenses are also important when deciding between funds within the same form. The index fund prospectus and many websites like Morningstar, Yahoo Finance and MoneyCentral (MSN) provide index fund expense data for open-end funds and ETFs. Other factors include the importance the investor places on short selling, trading options on index funds and immediate trade execution. These other factors are available only with ETFs. Also, most open-end funds can automatically reinvest dividends and capital gains, but ETFs generally cannot.
The third step involves contacting an investment company or broker. To invest in an open-end index fund, an investor must directly contact an investment company or a firm that brokers the investment company’s shares. However, investors buy ETFs only through a broker. Investors with knowledge and access to information about investment portfolio construction and index funds may be served best by directly contacting an investment company or using an online brokerage firm. Other investors may be better served by contacting a full-service brokerage firm that provides information and advice.
Index funds provide an efficient investment medium worthy of consideration by long-term investors.