How to Buy an Index Fund

Before you can invest in the stock market by buying a low-fee index fund, you'll need to do some paperwork and find a brokerage account to buy shares of the mutual fund or exchange-traded fund.

In this clip from Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss everything you need to buy an index fund and why an index mutual fund may be a better option for the average person than an index ETF.

A full transcript follows the video.

This podcast was recorded on Sept. 14, 2016.

Gaby Lapera: 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.

Jordan 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.