Three Things You Need to Know About Low-Cost Index Funds

By: Jilly Pretzel

Maybe you’re thinking of adding an index fund to your portfolio. You’re looking at Mutual funds, ETFs, actively and passively managed funds… and you’re not quite sure what to pick.

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You might have heard of low-cost indexes before, and if you’re new to the stock market and looking for a steady investment that won’t take too much time to keep up with, low-cost index funds might be for you. But, before you invest, it’s important to know exactly what a low-cost index fund is.

In this article, we’ll break down the basics of a low-cost index fund so you can know how they compare to other investments, and whether or not they’re right for you.

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1. They're Designed to Mirror the Performance of One of the Major Indexes

The first thing to know is that each low-cost index fund follows a major stock market index. What’s an index you say? It’s a selection of stocks designed to represent the broader market. You’ve heard of at least some of them before, like the S&P 500 and the Dow Jones Industrial Average, and some of them you probably haven’t heard of, like, perhaps, the iShares MSCI Kokusai ETF.

So, these indexes track a certain number of stocks that all have something in common so that investors can get a sense of what that corner of the market looks like.

For example, the S&P 500 tracks the top 500 largest publically traded companies. Just because the S&P goes down one day doesn’t mean every business in the index is down, and it certainly doesn’t mean every big business in America is down, but it gives investors an idea about a certain number of stocks and what they might represent. It’s pretty handy because if someone wanted to get an idea of how the stock market is doing, without spending hours checking the price of each stock, they can look to the Dow Jones or maybe the DJIA, get a broad sense of the market, and get back to lunch.

Of course, indexes track different parts of the market (if big business isn’t your thing, you might look to the Russell 2000, which represents the 2000 smallest publicly traded companies) and while every index is different, they’re each very valuable to certain investors.

Of course, you can’t buy into a major index like the Dow Jones or the Russell 2000, these are just used for tracking. However, you can invest in a low-cost index fund that invests in those same stocks that those indexes track. So, you could find a low-cost index fund that mirrors the Dow Jones, investing everywhere the Dow Jones tracks.

These investments, these low-cost index funds, often prove to be a good, long-term investment

2. They're Passively Managed

Low-cost indexes are low-cost because they’re what’s considered a “passively managed fund.” Unlike traditional, actively managed funds, where managers analyze and evaluate which individual stocks to acquire, the manager for a low-cost index fund doesn’t have to actively analyze and select investments. This is of course because the portfolio follows an index. If it’s following the Dow Jones, the stocks are set.

Granted, the stocks can change every so often, but it’s rare. If a company falls off the S&P 500 because it’s no longer one of the top 500 publicly traded companies, the manager can change the index. Still, updates and changes like that happen rarely, sometimes just once a year. This is great news because since the manager’s fees are so low, investors can buy into these index funds for very little.

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3. There are Plenty of Index Funds to Choose From

If you’ve already started looking into index funds, you’ve probably already found that there are thousands of them. They all follow different stocks and represent a different part of the market. This means you’ve got plenty of options when it comes to choosing your low-cost index fund but it also means you’ve got some serious decisions to make.

When it comes to indexes, it all depends in what you want to invest in. Do you want to focus more on big businesses? Small businesses? Restaurants? It’s up to you. Though, no matter what indexes you gravitate to, you should look out for a few key things.

First, you should ask yourself how broad an index is. If you’re worried about your investment and want something that will steadily climb over a long period of time, go with something broader, with more carefully chosen stocks. Look for a “total stock market index” rather than a “small-cap index,” which can be a little riskier.

You also want to look for a low tracking error and an experienced fund manager. The tracking error measures how close the fund’s returns match the benchmark. If you see a low tracking error usually means a good index fund manager, which can be very valuable. When you find one of these, you usually find the other.

Finally, you should look into the total cost including the trading fees and expense ratios. Many people choose low-cost index funds because of how inexpensive they are. Make sure that expectation meets reality and you’re paying a fair price before you buy in.