Master Index Investing (Clear and Simple)

What you'll learn:

➤ What Is Index Investing?

Index investing is like making your money work smarter, not harder. You don’t need to be a detective hunting for the best stocks or bonds. You can simply buy a bunch of them all at once. Let’s break it down for you.

Picture this: Imagine you have to find a tiny needle in a giant haystack. It sounds tough, right? Well, way back when, a smart person named Jack Bogle had a better idea.

He said, “Why not just buy the whole haystack?” That’s how the idea of index investing began. It’s easy to do, doesn’t cost much, and it spreads your money out to lower the risk.

Here’s the good part: Index investing has been pretty successful. It has done better than many other kinds of investing where people actively pick and choose which stocks to buy.

For instance, a fund called the Vanguard 500 Index Fund (VOO), which follows the S&P 500 Index, has done better than 76% of other funds that pick and choose stocks. It’s been like this for the past 15 years.

Now, more people are using index investing. Almost 60% of the money in U.S. stock funds is in index funds or exchange-traded funds (ETFs). That’s way more than ten years ago. And guess what? You can find an index fund for almost anything you want to invest in. So, there’s something for everyone!

But don’t get us wrong; some people still like to pick their own stocks, and that’s fine too. It’s just that, on average, they’ve had a tough time doing better than the S&P 500. That’s why many folks prefer index investing these days. No one wants to follow a losing strategy.

But here’s the catch: In recent years, index investing has gotten a bit more complicated. The education about it hasn’t kept up.

Before, it was all about following the whole stock market. But now, there are fancy index funds that aim to do better than the usual ones. Some even use tricky strategies that can be hard to understand.

That’s where we come in. We’re here to help you become a pro at index investing. Check out our guide below. We’ll show you the different choices in the world of index investing, whether you want to invest in stocks or bonds.

You can go for the basic ones that follow the whole market or pick something more specific. There are even complex options if you’re up for a challenge. We’ve got it all covered. So, let’s get started!

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➤ Traditional Stock Index Funds

These are your no-fuss, straightforward index funds.

They do two simple things: They follow popular stock market indexes like the S&P 500 or the Nasdaq-100, and they decide which companies to include based on their market value. The bigger the company, the more space it takes up in the fund.

In a nutshell, what you see in the index is exactly what you get in the fund. That’s what makes traditional index funds great for your main investment pot. Chris Huemmer from FlexShares ETFs sums it up nicely: “It’s all rules-based, so there’s no strategy drifting off course.”

But here’s a friendly tip: Before you pick one, take a moment to understand the index fund you’re considering. Not all index funds are the same. Two funds might have similar names and goals, but they could hold different stocks.

For instance, let’s look at three small-company index funds: iShares Russell 2000 ETF (IWM), SPDR Portfolio S&P 600 Small Cap ETF (SPSM), and Vanguard Small Cap Index (VB). Each of these follows a different index, so they perform differently.

Vanguard’s fund, for example, has larger companies on average than the other two funds. This has made it perform better lately because bigger companies have been doing well.

The SPDR fund, on the other hand, holds more profitable companies because its index only includes firms that make money. So, in 2021, it did better than the other two small-company funds.

Here’s a good strategy: If you’re buying individual funds for big, small, and midsize company exposure, try to stick with the same index family. For example, if you have an S&P 500 index fund, pair it with an S&P SmallCap 600 index fund.

This way, you won’t accidentally end up with the same stocks in both. In our Kiplinger ETF 20, a list of our favorite exchange-traded funds, we matched iShares Core S&P 500 ETF (IVV) with iShares Core S&P Mid-Cap ETF (IJH) and iShares Core S&P Small-Cap ETF (IJR).

If you’re more into mutual funds, you can consider Fidelity 500 Index (FXAIX) or Schwab S&P 500 Index (SWPPX) for large-company stocks. Or, go for a total market fund, which owns almost every publicly traded stock. The Vanguard Total Stock Market has both mutual fund (VTSAX) and ETF (VTI) options.

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➤ Strategic Index Funds

Now, let’s dive into a different kind of index funds – the strategic ones, also known as factor funds. These funds aim to beat a broad stock market index, but they do it with a unique twist. They don’t follow the traditional rule of basing investments on a company’s market size.

Instead, they focus on factors or traits of stocks that have a history of making good returns. These factors include things like:

Value: This means buying cheap stocks.
Size: It’s about investing in small-cap stocks, the smaller ones.
Momentum: These are stocks with prices on the rise.
Volatility: These are stocks with stable, low price changes.
Quality: These are financially healthy companies.
Yield: These stocks pay dividends.

You can add these factor funds alongside your regular investments to make your returns better or lower your risks.

Here’s the catch: Factor investing takes time to pay off. So, consider these funds as long-term investments. Some factors, like size and value, show their worth over several decades. Others, like quality, value, and momentum, can reward you in five or more years.

But, there’s a twist. These factors don’t always perform well at the same time. When the economy is having a hard time, low-volatility, value, and quality factors tend to do better, while momentum and size might lag behind. During a recovery, size, value, and quality tend to shine, while momentum and volatility might not do so well.

You’ll find funds that focus on one factor, like Fidelity and BlackRock’s iShares. And some funds group factors that work well together.

For example, momentum and low volatility make a good pair, as do quality and value. But there’s a debate about whether you should own all the factors at once. Some experts say yes, as it adds diversification benefits, while others say no, as it might dilute returns.

So, we suggest a flexible approach. One option is the Invesco Russell 1000 Dynamic Multifactor ETF (OMFL), which emphasizes different factors depending on the economic situation. It’s done well over the years, beating the S&P 500, but it’s been a bit more up and down.

Equal-weight funds are also a type of factor fund because they give equal importance to all companies, whether big or small. This helps you avoid putting too much money into popular stocks. But keep in mind, their performance can be a bit bumpy over shorter periods.

Now, there are funds that look at a company’s business metrics, like revenue and cash flow. These include:

Invesco S&P 500 Revenue ETF (RWL), which ranks stocks by their revenue and rebalances every quarter. It did better than the S&P 500 over three years but fell behind over five and ten years.
WisdomTree US Earnings 500 ETF (EPS), which holds profitable large stocks ranked by earnings. It beat the S&P 500 over three years but lagged over five and ten years.
Pacer U.S. Cash Cows 100 ETF (COWZ), which focuses on companies with strong cash flow. Over five years, it did better than the S&P 500.
Schwab Fundamental US Large Company Index (FNDX), which tracks stocks using sales, cash flow, dividends, and buybacks. It didn’t do so well over one and five years but performed better than most large value funds in most years over the past decade except 2022.

You can include these funds in your portfolio to boost your returns alongside your core investments.

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➤ Thematic Index Funds

Now, let’s talk about thematic funds. These funds let you put your money where your heart is. No matter what you’re passionate about, there’s probably an ETF that’s all about it. Here are a few examples:

Direxion Work From Home (WFH): This one is for people who love working from home.
ProShares Pet Care ETF (PAWZ): For all the pet lovers out there.
iShares Global Clean Energy ETF (ICLN) and Invesco Solar ETF (TAN): If you care about clean energy and the environment.
Global X Robotics & Artificial Intelligence (BOTZ) and Global X Autonomous and Electric Vehicles ETF (DRIV): These are all about technology and innovation.
Some folks, like Nick Kalivas from Invesco, also put funds that follow environmental, social, and corporate governance rules in the thematic category.

Now, here’s the thing about these funds. They’re best for money that you can put away for a while. They focus on trends that will take some time to play out. As Rachel Aguirre from iShares says, “These funds tap into growth that will happen over a long time.”

But be ready for a bit of a rollercoaster ride. These funds can be pretty jumpy. Take the Ark Innovation ETF (ARKK), for example. In 2020, it shot up by 153%, but in 2021, it fell by 23%.

Then, in 2022, it dropped by a whopping 67%. But it bounced back in 2023. So, buckle up for a wild ride if you’re into thematic funds.

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➤ Quasi-Index Funds

The line between index funds and active funds is getting a little blurry. Some folks even call the strategies we’re about to discuss “actively managed,” but we like to think of them as quasi-index funds.

Buffered ETFs: These are a smart choice if you want to keep your money in the stock market but don’t want to deal with big drops. Buffered ETFs are also known as “defined outcome” funds. They invest in options connected to a broad index, like the S&P 500. Here’s how they work:

You get some protection from stock market losses over a year, but there’s a limit to how much you can gain.
The amount you give up in potential gains (the cap) depends on how much protection you get (the buffer).
For example, the Innovator S&P 500 Buffer ETF July fund (PJUL) had a 9% buffer and a 19.24% cap. So, if the S&P 500 drops by up to 9% over the next 12 months, you don’t lose anything. But if it falls by 15%, you only suffer a 6% loss.

Most buffered ETFs are linked to the S&P 500, but some follow other indexes like the Nasdaq-100, the Russell 2000, or the MSCI EAFE. After a year, the fund buys new options, setting the buffer and cap for the next 12 months. You can hold onto these funds as long as you like.

Keep an eye out for buffered ETFs from Innovator, First Trust, AllianzIM, TrueShares, and Pacer. To get the full downside buffer, buy shares within a week of the 12-month stretch start date. If you invest later, the buffer and cap will adjust based on the fund’s value each day.

Direct Indexing: This was once only for wealthy folks, but it’s now available to regular investors thanks to free trading and lower investment minimums.

With direct indexing, you own individual stocks from an index, or a chosen set of them. You can also make changes to match your needs or values. Tax-loss harvesting is a big deal here:

Let’s say you’re tracking the S&P 500, and you have Exxon Mobil shares trading at a loss in your portfolio. With tax-loss harvesting, you’d sell those shares to offset gains in other investments. Then, you’d replace Exxon with a different but similar stock from the index, like Chevron, to keep the right balance in your portfolio.
This helps reduce your capital gains tax, meaning more of your money stays invested.

The more money you have in your portfolio, the better this strategy works. It only works in taxable accounts, not retirement ones. But it’s not for everyone.

Some say you need at least $2 million to make it worthwhile, while others believe only the wealthiest, highest-tax-bracket folks or those passing their account to their heirs should go for it. Fees usually range from 0.2% to 0.4% of your assets per year.

If you’re keen on direct indexing, consider finding an advisor who offers the service. Not all do because it’s extra work and comes with a cost. Some brokerage firms also offer personalized indexing services.

Fidelity’s Managed FidFolios, for example, have a $5,000 minimum and charge a 0.4% fee. Schwab’s minimum is $100,000, and the fee is 0.40% for balances under $2 million, but you need to work with a Schwab financial consultant.

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➤ Bond Indexing

While stock indexing gets a lot of attention, bond indexing is quietly gaining popularity. Historically, most actively managed bond funds performed better than their benchmarks over the long term.

However, things are changing. In 2022, a challenging year for bonds, bond index funds outperformed their active counterparts. As yields on bonds have risen, more investors are turning to bond funds, especially passive ones.

But, there are a few things to keep in mind when it comes to bond indexing:

Not Every Bond Is Included: Unlike stock index funds that hold all the stocks in the index, bond index funds often hold a sample of bonds. This can lead to tracking errors, which is the difference between the fund’s return and the index it follows.
Yields Can Change: Unlike individual bonds that you can hold until they mature, bond fund yields can change as the mix of bonds in the portfolio changes and interest rates fluctuate.

Traditional Offerings: Traditional bond index funds typically follow the Bloomberg U.S. Aggregate Bond Index (the Agg). It wasn’t designed to be a comprehensive benchmark and is not very diverse, with around 70% of it being government bonds. It also excludes some sectors like high-yield debt. However, these funds still make good core holdings.

Fidelity U.S. Bond Index Fund (FXNAX) is a favorite, with an expense ratio of 0.03% and a yield of 4.5%.
iShares Core U.S. Aggregate Bond ETF (AGG) is another option, with a 0.03% expense ratio and a 4.3% yield.

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You can improve the diversity of your bond portfolio by adding small doses of bank loans, high-yield corporate bonds, and preferred securities. For high-yield, consider the SPDR Portfolio High Yield Bond ETF (SPHY), which yields 8.5%. The Invesco Senior Loan ETF (BKLN) is a good choice for floating rate funds, yielding 8.6%. If you’re interested in preferred stocks, check out the iShares Preferred & Income Securities ETF (PFF), with a yield of 6.6%.

Factor Funds for Bonds: Factor-based bond funds are a relatively new category, but there are a few worth considering. They focus on factors like quality and value:

FlexShares High Yield Value-Scored Bond Index Fund (HYGV) emphasizes quality and value, yielding 9.7%, with a 0.37% expense ratio.
iShares High Yield Bond Factor ETF (HYDB) focuses on quality and value, with an 8.6% yield and a 0.35% expense ratio.
The Fidelity Low Duration Bond Factor ETF (FLDR) is an ultra-short-term bond fund that yields 5.7% and has a 0.15% expense ratio.

Laddering for Income: Some investors create bond ladders to manage income. This involves buying bonds that mature at different intervals. As each bond matures, you reinvest the principal in longer-term bonds. Invesco and iShares offer target-maturity ETFs, allowing you to build bond ladders with index funds:

Invesco offers BulletShares, which include investment-grade corporate debt and high-yield bonds, with maturity dates between 2023 and 2032. Expense ratios range from 0.10% to 0.42%.
iShares offers iBonds, with tracks for Treasury bonds and investment-grade corporate debt, maturing between 2023 and 2033. Expense ratios vary from 0.07% to 0.10%.

These ETFs provide instant diversification and liquidity, making bond laddering easier for investors.

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➤ Mutual Funds or ETFs?

Deciding between an exchange-traded fund (ETF) and a mutual fund largely comes down to personal preference.

Both options offer diversified exposure to various markets in a single investment, pool assets from shareholders, and charge an annual expense ratio. However, there are some key differences to consider:

Trading: Mutual fund trades happen once a day, usually after the market closes. In some cases, you might have to pay a transaction fee when buying mutual fund shares. ETF shares, on the other hand, trade during the day like stocks and generally don’t involve fees at most brokers.

Minimum Investment: Some mutual funds have no minimum investment requirement. However, for Vanguard index funds, you typically need $3,000 to get started. ETFs don’t have this high minimum requirement – you can start with the cost of a single share.

Expense Ratios: ETFs generally have lower expense ratios than mutual funds. One reason is that most ETFs are index funds, which tend to be less costly to manage than actively managed funds. Additionally, ETFs avoid certain expenses that mutual funds incur, such as fees to list the fund on a brokerage firm’s no-transaction-fee platform.

Capital Gains Distributions: ETFs are designed to be more tax-efficient compared to mutual funds. ETFs don’t directly buy and sell the underlying securities in their portfolios – third parties handle these transactions.

This means ETFs are less likely to distribute capital gains to shareholders. (Remember, you still owe capital gains taxes when you sell your ETF shares.) Mutual funds, however, must pass on any gains from selling securities to shareholders at least once a year in the form of a capital gains distribution.

This doesn’t apply if you hold the fund in a tax-advantaged account like an IRA or 401(k). But if you own the fund in a taxable account, you might face an unexpected tax bill.

So, your choice depends on your investment goals, trading preferences, and tax considerations. Both ETFs and mutual funds have their advantages, and the right choice for you will depend on your specific circumstances.

➤ Final Thoughts

Index investing offers a straightforward and cost-effective way to build a diversified portfolio for your financial goals.

Whether you opt for traditional stock index funds, strategic factor funds, thematic ETFs, or even quasi-index funds, it’s important to choose the approach that aligns with your risk tolerance and investment objectives.

Additionally, for those exploring bond indexing, understanding the different types of bond funds and their unique features can help you make informed decisions about your fixed-income investments.

Whether you prefer ETFs or mutual funds, remember that the key is to align your choice with your trading style, investment horizon, and tax considerations. Both have their merits, and with the right approach, you can use index investments to help secure your financial future.

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