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Investing in Index Funds
requires You Know one thing...

Index funds have gained a lot of popularity over the years, as more and more people are forced to fend for themselves when it comes to funding their life after work. Investors with retirement accounts wanted a low effort way to generate a profit.

What are Index Funds? Why should you consider them?

These funds are financial assets, created to mimic the performance of market "averages". They offer a low cost way for an individual investor to practice index investing...which is a close relative of "passive investing".

Since market indexes are widely recognized and followed, creating a fund that copied their performance was a win-win.

Investors can get exposure to a large variety of investments without having to buy single shares of each one. If you had to buy and track each one separately, it would kind of defeat the purpose of "passive investing".

Financial companies get a low cost, low risk way to earn a commission (i.e. management fees).

The One Thing You Need to Know

Usually, a firm providing fund buys all of the financial instruments or securities of a specific index, and just gives you a portion of that portfolio. So the firm that owns a S&P500 fund will likely own all of the stocks that are part of the S&P500.

But that doesn't mean you'll earn the same return as the index. The fund will typically underperform the index it follows by a fixed amount. That amount is the the expense ratio...or the fee that you pay to the firm for providing the fund.

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

What to Buy - Your Investing Choices

There are several ways to look for index funds. One way is to research the provider. For example, you could go to the websites for:

This is a great way to select options based on reputation/management practices. But it doesn't tell you what types of assets are in the fund(s) (i.e. what you're buying).

It's in the best interest of each company to offer as many different funds as possible, but that doesn't mean they're meet your needs. For example, check how long the fund has been around, and how long a particular manager has managed the fund. This will let you know who's been responsible for fund performance (both good AND bad)!

The next natural grouping is by the asset class:

And of course, there are different strategies you can choose from, including:
  • Inflation-Protected
  • Volatility-Based
  • Inverse or "Short" (-1x)
  • Leveraged (2x,3x)
    • Leveraged Inverse or "Short" (-2x, -3x)
  • Long & Short (Alpha)
  • Absolute Return

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

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.