Everything You Need to Know About Index Funds

Perhaps the only certain thing in investing is that index funds will continue to take the lion's share of new investment capital coming into the stock market. From 2009 to July 2016, passive index funds grew in every single year as investors added more money to low-cost funds. Meanwhile, active funds have experienced outflows, as investors pull cash out at a faster rate than new cash is invested into them -- and the pace of outflows is accelerating.

On this edition of Industry Focus: Financials, join The Motley Fool's Gaby Lapera and Jordan Wathen as they discuss everything you need to know about investing in index funds, why they're so popular, and why they may be a great investment for your retirement portfolio.

A full transcript follows the video.

This podcast was recorded on Sep. 14, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the Financials edition, taped today on Wednesday, September 14th, 2016, but you are listening to this on October 3rd. Happy October. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, an analyst in our financials bureau here at The Motley Fool. Hi, Jordan. How's it going?

Jordan Wathen: It's going well, how about you?

Lapera: Awesome, I'm glad to have you on the show today. Today, we are going to attempt to answer a listener question from Abrielle Elise. She would like to know how to purchase an index fund. There's a lot that could potentially go into that. I decided to make it enough to have an entire show. Get ready to learn all about index funds. Jordan, I'm going to start with an extremely softball question. What is an index fund?

Wathen: An index fund is, technically speaking, any kind of fund that invests in an index and isn't actively managed. An actively managed fund hires portfolio managers and analysts to find good stocks and bonds that they think will make great investments, and they generally seek to outperform the market, or outperform a benchmark. Index funds, on the other hand, they just buy the index. If you buy a traditional S&P 500 index fund, like Vanguard's 500 index fund, it buys and sells all the stocks in the S&P 500. That's all it does. If a stock is removed from the S&P 500, then the fund sells it. If a stock is added to the index, then the fund buys it.

Lapera: Just for our listeners, in case you haven't caught on to this, there are these things called indexes, and they work just like an index in a book. They list everything that's in the book. The index lists everything that's in that particular index, stock index, which is why it's called the S&P 500 Index.

Wathen: Right. The S&P 500 Index generally holds 500 of the largest companies in the United States, or that trade on U.S. markets.

Lapera: Right. You were talking earlier about mutual funds trying to beat their benchmark. Typically The benchmark is some kind of index.

Wathen: Right, typically it is an index. It depends. Bonds have bond indexes, bond investors aren't trying to beat stocks. And stock investors would hope that they could outperform bonds, generally, but they're not benchmarked to bonds.

Lapera: Can you name any other more commonly known stock indexes for our listeners?

Wathen: The S&P 500 is a large-cap index. It holds 500 of the largest stocks in the United States. On the other end of the spectrum would be, say, the Russell 2000, which holds small-cap stocks in the United States.

Lapera: Just so our listeners know, cap refers to market capitalization. A large-cap stock would be a company whose market capitalization is above $5 billion. Of course, that figure varies depending on who you ask. But around $5 billion is good enough for our purposes. Small cap is, obviously, a lot smaller. When I say a lot smaller, I mean, say, $200 million. It's a lot, lot smaller.

Second question, why would you want to invest in an index fund?

Wathen: The primary benefit of an index fund is because they don't employ managers to oversee the portfolio and hire very expensive analysts to go find stocks or bonds for it, stocks and bonds they think will be good investments. They can pass on those much lower costs to investors. There's a group out there called the Investment Company Institute, and they basically collect information on the world of investment funds. In 2015, the average stock mutual fund charged an expense ratio of 0.8%. That's an actively managed fund, 0.84%. Now, index funds, on the other hand, cost 0.11% in 2015 -- roughly 1/8 the cost for an index fund compared to an active fund.

Lapera: That's a huge amount. I realized that when you're talking about anything that's preceded by zero point something, it doesn't seem like it would make a huge difference. But if you spread that amount out over time, you're losing a lot of money in fees. 

Wathen: Right. I just did it, but I hate when people put it in perspective of -- the amount of assets under management, put it into consideration of the average return over time. Let's say the S&P 500's average return might be 8%; we'll just go with that figure. If you pay 0.8%, you're basically giving up 1/10 of your return. If you pay 0.1%, you're giving up 1.25% of your return. It's an astronomical difference.

Lapera: It's huge. So, it's really important to look at expense ratios, which is something that we'll actually get to in a little bit. I think we've kind of touched on this, but an index fund can be a mutual fund or an exchange traded fund, because it's literally any fund that tracks an index. So it just depends on how you're buying it. We'll get a little bit more into that, because it gets into the costs.

The other reason why you might want to have an index fund is maybe you don't have a lot of time to pay a lot of attention to the stock market, but you would like your money to still continue growing. So you can just put your money into an index fund and let it grow passively. It's generally a much better place to keep your money and have it continue growing than a savings account, because at least it will keep pace with inflation, and perhaps exceed it a little bit, if it's doing what it's supposed to do. Basically, that sums up that passive investing is fun if you don't have a lot of time. The other thing that's really good about index funds is diversification.

Wathen: Right. Diversification, after costs and being a passive investor, it's one of the biggest benefits. To use an example, there's an index out there and it's very popular. It's called the Total Stock Market Index. It basically tracks every single stock in the United States that's a practical size to actually own. Vanguard's Total Stock Market Index for the United States holds more than 3,600 stocks, which is extreme diversification. The only stocks it voids are stocks with market caps, or market values, of less than $10 million, which are really just stocks that are too small for the fund to even hold, or buy and sell out of. To put that in perspective, there's this website out there where you can basically buy and sell private companies, and I've seen car wash chains sell for more than $10 million. At that valuation, you're not missing out on much. It's basically the stock market, the whole thing -- 99.9% of it.

Lapera: Yeah. But if you want to get a little bit more specific than that, you can be, like, "I want to invest in a consumer goods index fund, and it's an index fund that tracks consumer goods companies."

Wathen: Yeah. There's a new ETF that came out recently. It's technically an index fund because it tracks an index, and it trades under the ticker symbol SLIM. It actually tried to invest in companies that would make money on the growing obesity problem. So, these can get extremely specific.

Lapera: That's crazy. That's a very clever ticker symbol. I always get a chuckle out of some of them. That's really smart, I'll have to look into it. Basically, diversification is the opposite of having all your eggs in one hand basket. You basically have one hand basket for every egg you've ever bought in your entire life, which keeps them all gently padded and safe. Of course, diversification, moving on to our next topic, can be a disadvantage. For example, say that you bought Apple (NASDAQ: AAPL) in 1990 when it was still really cheap. Right now, you would have a lot of money. But if you invested in an index fund that Apple was a component of in 1996, you would still have more money than when you started, but you wouldn't have as great of a return as you would have with solely having just invested in the index fund than you would have if you had just invested in Apple.

Wathen: Right. And some people call that "diworsification," which is a play on diversification. But if you think about the legendary investors of the world, like Warren Buffett, he wouldn't be anybody today if you made him go buy 1,000 stocks. No one would even know his name, if he had to, in a given time, own 1,000 stocks. Not that his returns would have necessarily been good or bad, but Warren Buffett made a fortune because he was super concentrated into his best ideas. If you buy an index fund, by definition, you are rarely, if ever, super invested in one or two or three or 10 companies.

Lapera: Right. So while diversification insulates you from a company going completely broke, because there's so many other companies that are doing fine in the index, but it also insulates you from making mega profits that you could if you picked one stock, in particular. For reference, I think Warren Buffett has around 50ish stocks in his portfolio right now, which is not a lot, especially considering that he has an entire investing team figuring out what to buy. He could have a lot of stocks.

Wathen: Right, especially considering his big four makeup. I don't know the percentage offhand, but it's a very significant percentage of that amount.

Lapera: Yeah. The other thing we talked about earlier is fees. This is something that you have to take into account when you're buying an index fund. The other thing you need to keep in mind when you're buying index funds, at least as an ETF, is that you are probably going to have to pay a commission.

Wathen: Right. And really, this goes for any fund, whether it's an exchange traded fund, or even a mutual fund, a mutual index fund, is that you will probably have to pay a commission. Some companies offer commission-free trades. Some brokerage houses do. But in general, those tend to be the higher expense ratio funds, so be careful with that, as a general rule. Especially with exchange-traded funds, because ETFs are bought and sold like stocks on the stock market. You have to pay a commission, just like you would if you bought and sold shares of Apple.

Lapera: Yeah. And the final disadvantage related to diversification is that you are never going to outperform the market. By definition, you can only do as well as the market does. Lucky for you, the market, historically, has always risen over time, even if there are some giant dips in the intermediate, in the short term. But you're never going to get a huge winner of a stock by investing in an index fund, which means you'll never have the satisfaction of rubbing it in your boss' face when your stock picks outperform his. Heh.

Wathen: And that's not such a bad thing. We don't want to scare people away from this. The average active stock picker isn't going to beat the market anyway after costs.

Lapera: That is super true.

Wathen: So take that into consideration.

Lapera: Yeah. In fact, the average actively managed mutual fund is also not able to beat an index fund.

Wathen: Right, exactly. If Harvard MBAs can't do it, then you can't be too upset about it.

Lapera: I think it's something like, only 20% of mutual funds outperform their benchmarks. Something absurd, like 80%, do not. Keep that in mind. Let's get to the nitty-gritty of actually buying one. There are fees involved in buying an index fund. We mentioned the commission, if you're buying an ETF, but that's the same as if you're buying any other stock. There's also purchase and redemption fees. Can you get a little bit into those for me, Jordan?

Wathen: In the past, there used to be these fees called loads, and they've gone by the wayside. Basically, what a load was was an upfront fee, and sometimes a back-end fee that you would pay to buy or sell a mutual fund. Eventually, people figured out that paying 3% just to buy a mutual fund was a bad idea, and luckily, the world is changing and people are becoming more cognizant of cost, so they're going away. But purchase and redemption fees still exist. You just want to be really aware, really cognizant of the fact that there can be purchase and redemption fees on some funds. Even Vanguard, which is known for keeping costs as low as possible, charges some purchase and redemption fees on some of its bond index funds, for example.

Lapera: Yeah. What you would be looking for in the text -- because whenever you buy an index fund, you can go online and the companies are required to provide you a lot of information about them. Or if you really want to, you can ask for a paper copy of this. But there should be something that says load or no load, and you're going to be looking for a no load fund.

Wathen: Right. Even no load funds can have purchase and redemption fees.

Lapera: ... and those will also be listed, as well. So make sure to look at that. And the other thing that we touched on earlier is expense ratios. If you happen to be buying it as a mutual fund instead of as an ETF, you want to see how much the expense ratio is. It still matters for the ETF, but a little bit less.

Wathen: Basically, what that does -- to give an explanation -- the expense ratio is the cost of holding that fund over a year divided by how much you've invested in. If you have $1,000 to invest, and the fund charges 0.5% to invest in it, you'd basically be paying $5 per year on that amount.

Lapera: Right. That's a really big thing you should check before you actually buy the fund, what fees are involved. Just to refresh, again, just in case, for whatever reason, you missed it -- it's purchase and redemption fees, whether or not it has a load, and the expense ratio. 

The other thing you want to look at is, what are they actually invested in? Are you interested in investing in the S&P 500? Are you interested in investing in utilities? Are you interested in investing in only certain market caps? There's so many different options, like Jordan mentioned. That's the first thing -- what are you actually investing in if you buy this? And again, the companies are required to say what is actually inside the fund. I don't know if they actually list specific companies, but most of the time, they'll tell you, at least, what sectors they're invested in.

Wathen: You can get a list; usually they'll provide a list with specific companies on their website. But more importantly, I would say to go to the website and click on what's called a summary prospectus, and that's basically a shortened version of everything you need to know. They're still long documents that can be 20-30 pages. But there will be a point in that prospectus where it will say, "This is the index fund we seek to track," like the S&P 500, "and this is how we do it." The S&P 500 tracking fund would buy all the stocks that are in the S&P 500, for example. 

Lapera: Right, it's basically a mission statement. That's the second thing, after fees, that you should look for. And the other thing to keep in mind is that index funds can have different strategies for how they invest. The most common one is market cap-weighted versus equally weighted funds. Do you want to talk about that a little bit, Jordan?

Wathen: Basically -- we'll go to the S&P 500, because I think it makes a great example. The S&P 500 is a market-cap-weighted index. So the largest company in the S&P 500, which happens to be Apple, makes up the largest share of the S&P 500. The smallest companies make up a much smaller share of it. So when a traditional market-cap-weighted index fund buys into the S&P, they put about 5% into Apple, and then I think it's ExxonMobil or Microsoft that's next, I can't remember. But they'll be 4.7%, and it just goes down the list until you get into fractional percentages. On the other hand, an equal-weighted index will basically take the 500 companies that are in the index and divide the money equally between them. So you have 0.2% of your money invested in every single stock if you bought an S&P 500 index fund.

Lapera: Right. It's up to you whether or not this matters to you. If you do an equal-weighted fund... it's up to you, really. If you feel there's a huge difference, then that's something you should keep in mind.

Wathen: Yeah. The biggest difference is, an S&P 500 fund that is market cap-weighted will have more invested in the largest companies, so it'll be much more of a larger "mega cap" index, whereas an equal-weighted cap one will have just as much invested in the smaller and mid-caps in the S&P 500. A mid cap would be equal to a large cap like Apple in an equal-weighted fund, whereas in the market-cap-weighted fund, Apple will be significantly larger than the smallest companies in there.

Lapera: That's true. So depending on the index, if you end up with equal weighted, you have a potential for slightly more return, because it's easier for a smaller company to grow than for a large company to grow. Of course, the opposite is also true, it's easier for a small company to go out of business than it is for a bigger company to go out of business. So I don't know, it's up to you. That one is really 100% up to you.

The next thing that you need to do -- you've figured out what the fees are, you've figured out what the index fund is actually invested in, and you've decided, "I want to buy this index fund." The first thing you need to do is make sure you have a brokerage account.

Wathen: Right, you need to have a brokerage account. At least, if you're buying a mutual fund, you can go to the fund company. Vanguard has -- I'm just using them as an example -- brokerage accounts, and they have mutual-fund-only accounts. The difference is that a brokerage account can buy stocks in that account, whereas the mutual fund only, you can only buy mutual funds. But yes, you need to have a brokerage account. And ideally, if you're doing this, you should probably do it in a retirement account, an individual retirement account.

Lapera: If you don't know this -- in most retirement accounts, and I'm struggling just thinking of one where you can't, you can buy stocks or index funds within the retirement account. For example, if you have an IRA, you have a total contribution limit for the year of $5,500, that's among all your accounts, total, and you can have that money just sit there. That's an option, or you can invest it into a stock or index fund -- really, whatever your heart desires. 

Wathen: The important thing to remember is that you can have multiple IRAs. If you want to open an IRA with Fidelity and buy a Fidelity fund or a Fidelity index fund, you can do that. If you want to open an IRA also at Vanguard, you can do that, too. The only limits on IRAs is not how many accounts you have, it's only the amount that you contribute to it each year. I don't think a lot of people are aware of that.

Lapera: Right. So you can either get it from a brokerage account -- say you have a brokerage account with Fidelity, you can buy it in a retirement account. The other option you mentioned was, you can buy it directly from a company -- so, you open a brokerage account with the company. So let's do Vanguard again, because it's my favorite. We'll cover that. I'm not advocating that you buy it just because it's my favorite later. Anyway, say you want to open a position in an index fund from Vanguard. You can open one with Vanguard. Most companies actually allow you to buy index funds from their competitors, anyway. So if you wanted to, you could open an account with Vanguard, and then also buy a Fidelity index fund from your Vanguard account. 

There are a couple things you need to make sure of. You often get dividends from these index funds. You should set up something called a DRIP plan, which is a dividend reinvestment plan. I prefer having my dividends automatically reinvested. So instead of getting a check every month, I just have that automatically reinvesting into the fund, and you can get a fractional share. But the one thing you really want to make sure with that is that you don't pay a commission every time the dividend gets reinvested.

Wathen: Right. To give an example, the S&P 500, I think the yield on it right now is somewhere around 2%. If you invest, say, $5,000 into an S&P 500 fund, you will have dividend distributions of probably of about $100 over the next year. To reinvest that and pay a $10 commission on it is just insane. That's 10% off the top, and it really adds up over time. That's why I would recommend for the average person -- and I hate saying this because financial advice is so individual -- the average person is probably better off in an index mutual fund versus an exchange traded fund, because mutual funds generally have no or low commissions compared to ETFs.

Lapera: Yeah. If you are wondering whether or not your fund charges you a commission every time you use your DRIP, you just need to check the paperwork. They are legally required to disclose all of this to you. In terms of actually how to purchase one step by step, it's difficult to say, because everyone's brokerage accounts look different. But somewhere, there should be a box that lets you type in a ticker, and a button somewhere that says buy. Make sure you have enough funds in your account, and make sure that you're aware of all the things we talked about ahead of time. Do you have any last advice for how to buy an index fund, Jordan?

Wathen: The thing is, every brokerage firm is different, so I can't say, "Go here and click this," and have you buy it. I would just say, if you have any doubt whatsoever, just give them a call. The only thing brokerages really do anymore is provide customer service. Anyone can execute a trade today, it's not a big deal. But really, if you're going to pay them fees, you should make use of the customer service -- just call them up and ask, honestly.

Lapera: Yeah, that's great advice. So just to sum up, index funds, it's not cool but they work. (laughs) Make sure you check for fees. Make sure you know what you're actually investing in. And know what the pros and cons, in general, of the index funds are. In case you missed it, there's the whole first half of the episode, just rewind. 

Thanks so much for joining us! I hope you guys are having a great October. If it's October 3rd, I'm either in San Francisco or Beijing. Hi from abroad, or potentially, the other coast! As usual , people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Contact us at [email protected], or by tweeting us @MFIndustryFocus. If you have any questions about this episode, I probably won't answer it, but someone else will, unless you're listening to this episode next year, in which case, I personally will probably respond to it. Thank you to Austin Morgan, who loves diversification, today's awesome producer. And thank you to you all for joining us. Everyone have a great week!