TThe arguments in favor of index investing are easy to understand: Mutual funds and exchange-traded funds (ETFs) that simply aim to replicate the performance of major indices tend to perform better over the long term than equities. actively managed funds with a similar purpose, at a fraction of the cost. While this simple argument has gained traction, index funds and ETFs have grown from less than 20% of all investor assets in 2010 to 40% at the end of 2020.

However, choosing the right fund can be difficult, especially as the number of options available is multiplying rapidly. In a recent report, Morningstar identified nearly 200 large-cap blended funds that could form the basis of a well-diversified portfolio. So how do you choose the best for you?

Choose index funds with the lowest expense ratios

The majority of index funds and ETFs charge an annual fee called an expense ratio. This small amount covers the operating expenses of a fund. (Yes, even though index funds simply seek to mimic the performance and makeup of existing indices, there are still costs associated with buying and selling the investments they hold, among other things.)

It is not entirely clear that you are paying an expense ratio because there is no line on your regular fund statements that shows how much the fees are costing you. Rather, it is a percentage of the fund’s assets that is automatically deducted from your returns.

“With indexing, fees are critical,” says Daniel Hawley, financial advisor in Walnut Creek, Calif. “Once you’ve identified an investment category in which you want to use indexing, look for the fund or ETF with the lowest expense ratio. “

Among the best total stock index funds you’ll find the Fidelity ZERO Total Stock Market Fund, which, true to its name, charges no fees. Schwab’s Total Stock Market Index takes an expense ratio of 0.03% and the Vanguard Total Stock Market Fund imposes an annual expense ratio of 0.04%. These very low expense ratios may suit you better than similar funds that charge higher fees over time.

Check the math. If you were to invest $ 10,000 per year over a 10-year period, with a gross return of 8%, you would end up with around $ 151,000 if the expense ratio was 0.63%. If the expense ratio of another fund that tracks the same index pursuing the same strategy was only 0.04%, you would have over $ 156,000. That’s a difference of $ 5,000, based on nothing more than the fees. Now imagine how that can multiply over a 30 or 40 year investment schedule.

Don’t sweat the difference between ETFs and index funds

When looking for funds that passively track an underlying index, you may start to wonder what the difference between an index fund and an ETF is, and more importantly, if it matters. Concretely, what separates an index fund from an ETF really comes down to how often the fund’s share price changes.

With an index mutual fund, you can place an order at any time, but the price of your buy or sell will be based on the value of all the underlying securities at the close of the current trading day. If you place an order after the market closes (4 p.m. ET for US exchanges), your trade will be processed at the next trading day’s closing price.

An ETF trades like a stock and its price changes throughout the trading day. Assuming you can buy and sell an ETF and a mutual fund without paying a commission, which is more and more common in the best brokerages these days, no matter what type of fund you choose, both that it is inexpensive.

That said, if you are just starting to invest on your own, whether in an IRA or a regular taxable account, an ETF may be the most practical choice.

Many mutual funds require a minimum initial investment which can be $ 1,000 or more. But if you open an account at a brokerage house, you can start with an initial investment of a single ETF share, which will usually be much less than a minimum fund. You may even be able to start buying a fraction of an ETF.

In addition, ETFs often have an advantage in terms of expense ratio. Sometimes it’s mind blowing: The Vanguard Total Stock Market ETF has an expense ratio of 0.03% and the mutual fund version charges 0.04%.

Sometimes it’s more than a few hairs: the iShares S&P 500 index ETF charges an expense ratio of 0.09%, while the investor share class of the mutual fund version charges 0. , 35%. When choosing between mutual funds and ETFs, however, one fundamental point remains: go for the vehicle that allows you to recreate an index that is cheapest.

How index funds work best in a portfolio

There are different ways to use funds in an investment or retirement portfolio. You can rely exclusively on indexation, this is the approach favored by robo-advisers, usually with ETFs. Alternatively, you can mix index funds with actively managed funds.

Hawley uses the “core and explore” approach for its clients’ portfolios. Low-cost index funds and ETFs are the basis, but he also chooses actively managed funds that he believes will offer more attractive risk-reward opportunities.

Whichever approach you choose, the key is to focus on indexing in the parts of the market that are often referred to as “effective”. This is the trading language for a market where there is so much information available and transparent trading that it is difficult for active management to outperform.

Morningstar’s Asset / Liability Barometer report compares the average performance of index funds in a specific investment category with the performance of actively managed funds. Across all categories, less than one in four active funds outperformed their index counterparts in the 10 years to 2020.

In the most efficient markets, indexation has been even stronger. Only 8.4% of actively managed large cap blended funds, 9.3% of large cap growth funds and 14% of high value funds managed to outperform their index counterparts in the last 10 years to 2020 Less than three in 10 of core intermediate bond funds outperformed index funds in the category.

In markets where the information available is less uniform or a less uniform trading platform, active management has a better track record. Over the past 10 years, over 40% of active funds investing in emerging stock markets, high yield bonds, corporate bonds, real estate and US small and mid-cap growth have outperformed index funds .

How to build a portfolio with index funds

If you want to keep it simple, you can build a fully indexed portfolio with just one fund. If you want more control over the makeup of your asset allocation, you can get the job done with just two or three funds.

• Choose a target date fund. For a retirement portfolio, you can choose a target date fund. All you need is a fund with a year in its title that is close to the age of 65. That’s all ; you have finished. The target date fund handles all the uplift, investing in a mix of equity and bond or ETF funds depending on your investment schedule. Many target date funds exclusively use low cost index funds and index ETFs.
• Take the three-fund approach. Another simple approach is to create a three fund portfolio that includes a total stock index fund, an international stock index fund, and a high quality US bond index fund. This allows you to further customize your equity / bond ratio, but requires you to be slightly more active than with a target date fund.

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