Beginners Guide to Index Funds

This beginner’s guide covers index funds from top to bottom…

Updated: May 18, 2024
Matt Crabtree

Written By

Matt Crabtree

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Mutual funds and ETFs that track an index by investing in stocks or bonds are known as ‘index funds.’

If you know how to choose the correct fund and weigh the benefits and risks, mutual index funds may be a terrific investment for novice investors. Investing in index funds may be a good move in certain situations; here's what you need to know about them.

Beginners Guide to Index Funds: What is it? 

  • An index fund is a group of stocks, bonds, or other vehicles making up an index. 
  • These investments are classified in accordance with criteria such as location, firm size, and industry.  
  • They aim to duplicate the performance of a certain market index, such as the Dow Jones Industrial Average.
  • Your index funds provide an inexpensive method to invest in a wide range of businesses with a single purchase.
  • It’s reliable and modestly diversified; but has limited adaptability compared to tailored portfolios. 

Index funds' returns are designed to replicate those of the index they monitor, so investors cannot expect to beat the market with them. Although you can't buy an index itself, you may purchase shares in a fund that tracks that index.

Some index funds incorporate derivatives or depart significantly from the index's original methodology, but the vast majority of index funds are mutual funds or ETFs that invest equally in all of the stocks comprising the index. 

In this detailed beginner’s guide to index funds, we go over what you should know before taking out investment cash from your online bank account. 

Index Funds Examples

Unlike actively managed funds, index funds are run automatically. 

Active management is the norm for investment vehicles like mutual funds and certain exchange-traded funds. Active fund managers are free to buy and sell any security in their market sector as frequently as they see fit in an effort to outperform the benchmark. 

Every day, thousands of indices monitor the ups and downs of different industries and marketplaces. Its value lies in their ability to serve as a barometer for the state and performance of that market. 

The 30 blue-chip companies that make up the Dow Jones Industrial Average form a broad market index. The United States Global Jets Index is a sector indicator that follows the worldwide airline industry.

Moreover, the index may be used as a measure of market performance or as a standard against which others are measured. Several common types of index funds and the underlying assets they follow are:

  • Invest in the 500 biggest U.S. firms with the Vanguard 500 Index Fund (VFIAX).
  • The iShares Russell 2000 Exchange Traded Fund (IWM) holds 2000 of the largest and most liquid small-cap companies in the United States.
  • For sustainable bonds, these are tracked by the Fidelity Sustainability Bond Index Fund (FNDSX).
  • The Global X Millennials Thematic Exchange Traded Fund (MILN) is comprised of firms based in the United States that stand to profit from the purchasing patterns of millennials.
  • Finally, investing in U.S. firms that benefit from remote workers is easy with the Direxion Work From Home ETF (WFH).

Beginners Guide to Index Funds — Buying Steps

Let’s continue with how to purchase an index fund as a beginner. When investing in an index fund, it's important to consider a few key considerations. 

★ 1. Set Goals 

Decide where your money will go and why. Just how dangerous is this financial move? Are you prepared to take a calculated risk in order to make progress? Your time frame is also a major consideration. How long do you plan to keep your investments? There is no “ideal” time window for making an investment, but there are times when certain strategies are more effective.

Many mutual funds and ETFs provide exposure to a wide variety of indices. You shouldn't just go with the first index fund you see; instead, you should look around and see what's available. Check the fees charged by similar funds before investing. What are the costs associated with purchasing, maintaining, and selling the fund?

★ 2. Choose Index 

Index funds may be used to follow any of several different indices. The Standard & Poor's 500 Index is by far the most commonly followed index since it represents 500 of the most prominent firms in the American stock market. A few more of the most prominent indices are listed below, with an explanation of the market sectors each one serves:

  • Dow Jones Industrial Average, S&P 500, and Nasdaq Composite are three major stock market indices in the United States, with the LSE for the UK.
  • The Russell 2000, the S&P SmallCap 600, and other small-capitalization stock indices exist for US markets.
  • Equity indices from across the world can be found in the MSCI Emerging Markets index.
  • For securities, an example is Bloomberg’s Global Aggregate Bond.

As well as broad indices, there are indexes based on filtering systems, such as sector indices, which are linked to specific sectors, country indices, which focus on stocks in single countries, style indices, which emphasise fast-growing business or value stocks.

★ 3. Select Fund 

Once you've chosen an index, you can generally find at least one index fund that tracks it. For popular indexes like the S&P 500, you might have a dozen or more trading choices all tracking the same index.

You should ask some fundamental questions if more than one index fund looks ideal for you.

To filter down your list, ask, which index fund comes closest to duplicating the index's performance? Two, which low-cost index fund is best? Thirdly, are there any constraints on an index fund that prohibit you from purchasing it? Lastly, does the fund company offer any other index funds that you'd be interested in investing in?

Depending on your responses, you may find it simpler to zero down on the best index fund for your needs.

★ 4. Buy 

Shares of the index fund you're interested in may be bought and sold using your bank account or credit/debit card by opening a brokerage account. You may also register an account with the mutual fund firm that manages the fund. Again, it's important to consider fees and other factors when determining how to purchase shares of an index fund. 

It might be cheaper to create an index fund account with the fund's issuing business than to go via a broker to purchase shares of the fund.

Nonetheless, many investors choose to keep all of their assets in a single brokerage account. The brokerage choice may be the most convenient approach to consolidate many index fund investments from various fund providers into a single account.

If you don't have a strategy on how to enter your investment, you run the chance of needlessly losing money on all of your ideas. Don't rush into a purchase just because you want to invest in something; instead, consider how you may be more smart in your approach.

Many people find that dollar-cost-averaging tactics, which remove emotion from such choices, are helpful in this situation. While making a purchase, some people rely on technical analysis.

Why Invest in Index Funds? 

If you're looking for a low-effort, high-reward approach to grow your money, index funds are a great option. You don't need to become a stock market specialist to reap the long-term benefits of index funds, which merely replicate the market's stellar performance over time.

Index funds are popular among investors for many reasons:

  • Saving time by using a good manager. You should spend as little time as possible learning about separate stock trades. A fund's portfolio manager may invest in an index that contains all of your target stocks for you.
  • You'll be able to make safer investments. Most stock market indexes include dozens, if not hundreds, of stocks and other assets, so your portfolio is less exposed to the failure of any one company.
  • It's possible to put your money in a broad range of different investments using index funds. The two main pillars of most people's investing strategies — equities and bonds — can be met by purchasing stock index funds and bond index funds, respectively. Yet, you may also invest in narrower, more specialised index funds that target subsets of the market.
  • Much less money will be required. As compared to other investment options, such as actively managed funds, index funds often have much lower fees. That's because all an index fund management has to do is buy the stocks or other assets that make up an index, rather than having to come up with their own stock choices and attempting to trade in those markets.
  • Taxes will be reduced for you. As compared to other types of investing, index funds have relatively low tax implications. For instance, unlike actively managed funds, index funds do not need to constantly purchase and sell their assets, thus they do not generate capital gains that might increase your tax liability.
  • Maintaining your investment strategy is much less of a hassle. With index funds, you can be certain that you will participate in the market's long-term development while having the convenience of having your money invested on a monthly basis and being insulated from short-term fluctuations.

Why Avoid Investing in Index Funds?

Index funds, for all their convenience, aren't right for every investor. While investing in index funds, you may face the following drawbacks:

  • Achieving market outperformance is impossible. For this reason, if you want to show that you are a better investor, you should avoid index funds, since their main purpose is to replicate the market's performance.
  • Without insurance, you are at risk for any losses. As the market drops, your index fund will drop as well since it follows the market's movement. 
  • Even if you're lucky, you won't always be able to invest in stocks you enjoy. The stocks you own and the stocks you don't own might vary widely depending on the index you chose.
  • Limited ability to select stocks you like. You may always have a mix of index funds and other assets to offer yourself more flexibility and deal with some of these drawbacks. But, if you want to rely only on index funds, you should be aware of and prepared for their limitations.
  • Tracking errors. The operational expenses of a portfolio are reflected in the tracking error that lowers an index fund's return to that of its parent index. A “tracking mistake” describes this situation. When choosing between two index funds that follow the same index, choose the one with the lower tracking error.
  • Differences in management philosophy: indexes lack objectivity. Companies that make up an index produce them. There aren't many checks and balances on who gets to make what decisions. Transparency is not guaranteed, and it may be altered by management strategies as a whole. There may be inconsistency if the same managers oversee both the index and the index fund.

1. GQGRX — Aggressive Russian Index Fund for Beginners

In the wake of Russia's invasion of Ukraine, some investors may have shied away from index funds with a high concentration of Russian holdings. When investors fled the market in February, rates dropped across the board for ETFs with exposure to Russia.

Last we last looked, 16.6% of The Emerging Markets Equity Fund managed by GQG Partners (GQGRX) was invested in Russian companies. On February 23 (when the first assault occurred), its output dropped by 2.6%…

Investors' attitudes shifted, however, as the war shifted in Russia's favour and the Rouble's strength steadily increased until it reached parity with the USD.

Hence, the GQGRX equity fund is ranked as the second-best EM index fund for Russia exposure. Noteworthy is the 10% allocation to Brazil, which had a roughly 20% growth in the first part of the quarter of 2022. Moreover, the energy sector accounts for about 18% of the portfolio, making it the best-performing industry in the world thus far in 2022.

More than other Emerging Markets (EM) funds, this one devotes a disproportionate amount of resources to materials (almost 13 percent of its total assets). Comparatively speaking, it places less of a focus on consumer cyclicals than the norm (around 13% vs 8%). In addition, energy equities account for about 21% of total assets.

2. SWPPX — Popular Index Fund for Beginners

The apparent flaw with the Schwab S&P 500 index fund is its reliance on the future performance of American corporations. There are worrying indicators that the American economy is heading downwards and into a prolonged downturn.

Several countries are now “de-dollarizing” their economies. Even more so, the US dollar is no longer the de facto international currency.

Although if the dollar is doing well right now, there are a number of warning signals that this is only a temporary uptick before a collapse, which will not be as severe in the United States as it would be in Europe due to the closure of the customer-favourite Tesco Bank in 2021.

As a result, the value of any investment in the S&P 500 index index will fall in tandem with the index. Yet, if you want to follow the performance of the S&P 500, this is the best index fund to choose. Of all, like any fund, it doesn't actually buy individual companies but rather pools them together to form a proxy for the index.

This index fund is said to be particularly interested in following the S&P 500's high-value and high dividend stocks. Therefore, a high return on investment is not the goal, but rather continuous expansion. One may purchase shares of this index fund either directly from the fund's website or via a participating brokerage. eToro is one such company. 

Several business kinds and segments of the market are represented. But, given the rapid transformations we're seeing in international financial markets, we can't be sure that this success will be repeated in the years to come. In general, this is the most logical choice for anybody seriously considering an investment in the S&P 500.

3. DVYE — Strong Index Fund for Emerging BRICS+ Nations

The world is seeing a new grouping of developing economies known as BRICS. Brazil, Russia, India, and China were the first to join. Adding South Africa was done later on. Now, BRICS+ is looking to expand to include even more nations.

DVYE index fund works hard at facilitating regional development, increasing participation of developing countries, simplifying essential resource utilisation (including commerce), supporting a multilateral trading system as opposed to a global framework, and providing disaster relief are all BRICS-related goals.

Nevertheless, technical terms aside. The growth in economic power is the driving force behind these countries' rising prominence. They are rising in importance as a major factor in the development of economies everywhere.

Since this fact has become more apparent, a hitherto unofficial alliance has solidified into legally binding treaties, with 2022 standing out as the year in which such formal pacts were signed.

In 2014, the combined GDP of the BRICS nations accounted for about a third of the world total (in terms of their spending power). More than 40 percent of the world's population lives there, making up more than 3 billion people.

To further encourage cooperation among these nations, the New Development Bank (NDP) was established as a BRICS bank. Its main office was in the Chinese city of Shanghai.

With its focus on dividends, the iShares Emerging Markets Dividend ETF seeks to replicate the performance of the Dow Jones EM Dividend Index, which is made up of stocks from developing economies with above-average dividend yields.

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Based on dividend return on investment and other hedging factors, the index tracks the performance of the top 100 dividend-paying developing market companies. Its holdings value is also around a 10-year low. So, one cannot predict its effects.

Beginners Guide to Index Funds (2024) — Summary

One group of investors tries to get access to the stock market, while another other aims to outperform it. 

An easy way to diversify your portfolio is by using an index fund. The purchase of a wide stock index fund is a convenient way for investors who wish to obtain exposure to the stock market but aren't yet familiar with specific companies to do so with a minimum of effort.

To make adjustments to your portfolio's exposure without selling any of your holdings, consider using index funds. If you have an S&P 500 index fund but don't believe it has enough healthcare equities, you may purchase an exchange-traded fund focused on that industry to diversify your holdings.

Yet, if you believe that the healthcare weighting in the S&P 500 is excessive, you can short the sector by investing in a health exchange traded fund that has a negative outlook.

Remember, you shouldn't use funds that track the average performance of the index if your objective is to outperform the market as a whole… Investing in stocks or bonds one at a time has various benefits.

With stock ownership comes the power to vote, as well as dividend payments made directly by the firm rather than as a percentage of the sector average. The money invested in individual bonds is refunded to the investor at the maturity date, whereas bond ETFs automatically roll over maturing bonds into new bonds on a permanent basis.

With eToro, you can buy index funds. There is a need for creative thinking among today's investors. eToro is a great example of diversification, since it trades in a wide variety of assets such as bonds, adding more variety like monetized domains to your personal portfolio.

Related Guides:

FAQs

How do index funds work?

How much, on average, do index funds return?

Where do you even begin?

Should I have one, two, or three index funds?

What are some low cost index funds?

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