Image source: Flickr user Rafael Matsunaga.
Thousands of professionals on Wall Street make it their mission to beat the market. For individual investors, though, simply matching the stock market's long-term return is enough for many to reach their financial goals, and index funds have helped millions of investors achieve their dreams. Yet many beginning investors don't know how to find the best index funds. Below, we'll take a look at some of the characteristics that set the best index funds apart from the rest.
1. Low expense ratios
The most visible benefit of an index fund is its low cost. Because all an index-fund manager has to do is to buy the stocks in the index, it doesn't take a lot of professional knowledge run an index fund, and so it doesn't make sense to pay anywhere close to as much as you would for an active manager doing research to find market-beating stock picks.
Many index funds sport expense ratios of 0.1% or less. Rivals will emphasize the value of an extra hundredth of a percentage point, but as long as your index fund's expenses aren't dramatically above those of its peers, then you'll get a big advantage over active management.
2. The right level of liquidity for you
Index funds are available either as mutual funds or as exchange-traded funds. Mutual funds trade once daily and have a fixed net asset value, so liquidity doesn't play a big role. For ETFs, though, liquidity can have a dramatic impact on cost.
For instance, popular ETFs like SPDR S&P 500 (SPY +0.81%) and iShares Russell 2000 ETF (IWM +0.41%) have trading volumes in the tens of millions of shares on a daily basis. This allows those ETFs often to have bid-ask spreads of just a penny per share, which can save frequent traders substantial amounts of money over similar index ETFs with larger spreads. The more you trade, the more a high-liquidity fund like the SPDR S&P 500 or the iShares Russell 2000 saves you compared to index peers with less liquidity. If you don't trade very often, however, it makes more sense to pick the cheapest expense ratio even if you might pay slightly more on the infrequent occasions when you trade shares.
3. Exposure to the investments you want
Different index funds track different parts of the stock market. The SPDR S&P 500 and the iShares Russell 2000 ETF, for example, are two useful index funds, but they give you different investment exposure. As their names imply, the SPDR focuses on the large-cap U.S. stocks in the S&P 500 index, while the iShares ETF holds shares of the small-cap companies among the Russell 2000 index.
Nowadays, you can find indexes that cover just about any part of the market you want. From the broadest possible market benchmarks to narrow niches defined by industry or investing style, you can find the index fund that matches up with the investments you want to own.
4. A track record of staying on target
Just because an index fund has the objective of matching an index's return doesn't mean it will automatically achieve that objective. In general, you can expect an index fund to provide the return of the index less any expenses of the fund. Yet the best index funds manage to close that gap through proprietary techniques, while inferior funds lose even more ground to the index's return than is justified by their expense ratios. When you research an index fund, make sure its past results match up closely to how the underlying index performed.
Index funds can be a great way to invest, but the smartest way to use these investment tools is to find the best index funds to meet your needs. That way, you can make the most of the opportunity that index funds offer their investors.
