By Chris Davis
This article provides information and education for investors. NerdWallet does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks or securities.
If your eyes glaze over when hearing the term “index funds,” you’re forgiven. But the dull, mathematical spirit of index funds is part of what’s made them such strong investment vehicles for decades running.
These vehicles are built to track various market indexes, which makes them an inexpensive and diversified option compared with, say, individual stocks. But that doesn’t mean that all index funds are built the same.
Keep in mind these five considerations when shopping for index funds:
1. What’s Your Investment Goal?
First, make sure to understand why you’re investing. Index funds are for long-term, hands-off investors, and often make up the backbone of retirement-focused portfolios. If you’re looking to tempt fate in the world of short-term stock trading, index funds won’t scratch that itch.
>> Plus, from Robert Powell's Retirement Daily on TheStreet: A Common Sense, Goals-Based, Approach to Your Investment Plan
But if you’re ready to get started, first assess your timeline. Will you need this money in five years? Ten years? Not until retirement? The longer your investment timeline is, generally, the more risk you can take on in the beginning, financial advisors say. And with more risk comes the potential for higher returns.
If you expect to need your funds in the next five years, the stock market might not be the best place to put your money. While lower-risk bond market index funds do exist, most index funds track segments of the stock market, which makes them a riskier choice for the short term.
2. What Level of Diversification Do You Want?
Diversification (which means owning a broad range of investments) is one of the most important considerations in investing, and index funds make it easy to achieve. But even within the world of index funds, diversification levels vary.
A total market index fund is about as broad as you can get; with a single investment, you’ll gain exposure to the nearly 4,000 companies that make up the U.S. equities market. Similarly, an S&P 500 index fund would invest in most or all of the roughly 500 companies featured in that index.
And then there are the less-diversified options. Index funds can be constructed by sector (such as technology or health care), company size, region, growth potential or other classifications. These index funds may be attractive to investors because of their potential to outperform the market as a whole.
However, it’s important to remember that you’re taking on considerable risk when your investments are concentrated within a specific category, opening up the possibility to underperform the broader market too.
In short, if you’d like to take a more active role in managing your portfolio and you’re comfortable with more risk, index funds that track narrower segments of the stock market may make sense. But if you’d rather minimize risk and take a more hands-off approach, a broader index fund may be a better fit.
3. What’s the Return Over Various Periods?
It’s tempting to focus on historical returns when shopping for index funds, but it’s important to remember past performance never guarantees future results.
According to Robert Isbitts, founder and chief investment strategist at Sungarden Investment Management, long-term returns may be more predictable from a mathematical standpoint than short-term returns, but that doesn’t take into account real-world implications.
“The stock market is a cyclical beast,” Isbitts says. “The classic risk is that just as you have accumulated most of the wealth you think you need to retire, and you are within, say, five years of retirement, the market cycle goes against you.
“The market’s long-term return does you no good if your portfolio’s peak value is subject to a market valley.”
So how can you plan for the future amid this uncertainty? When shopping for index funds, it’s better to find a range of returns you can stomach (such as acceptable three-year, five-year and 10-year returns) than to choose one based on a single historical average, Isbitts says.
Investors should ask themselves: How much volatility can I stand in the short term while holding out for a better long-term return? From there, investors can look for funds based on the upside potential, given the downside risk they’ve accepted. Learn more about the average stock market return.
4. How Expensive Is It?
Most index funds come with a management fee known as an expense ratio. These fees have fallen considerably over the last few decades, though they can still add up, particularly on larger balances.
Morningstar’s 2020 expense ratio analysis found the average asset-weighted fee of passively managed index funds was 0.13% in 2019. That means investors would pay $1.30 a year for every $1,000 in their investment balance. But that’s just the average — many of the most popular index funds have expense ratios lower than this. (Morningstar is a NerdWallet advertising partner.)
The truly staggering effect of fees comes into focus when viewed on a grand scale. An extra 0.5% in fees on a $250,000 balance equals $1,250 in added costs every year — and your retirement account’s balance should ideally be well above $250,000 for many of your working years.
5. Does It Have a Minimum?
Some index funds have a minimum investment required to purchase the fund. Many brokers offer a huge selection of funds with minimums of $100 or less — perfect for new investors with a smaller amount of investable cash — but some funds require more.
If minimums are a concern, feel free to pass on funds with that requirement. Generally, investors will be able to find suitable index funds with low or no minimum investment requirements through the major online brokers. What’s more, you might be able to buy shares of an exchange-traded fund (with no minimum) that closely resembles the index fund you’re interested in. Either way, not meeting a minimum shouldn’t be an excuse to stand on the sidelines of the stock market.
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Chris Davis is a writer at NerdWallet. Email: firstname.lastname@example.org.