What are Index Funds? And Which Should You Invest in?

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Allocating a segment of your investment portfolio in to an index fund is a great way to diversify risk. The reason for this is that instead of going through the exercise of analysing and evaluating individual stocks, you can instead make an investment across multiple companies and/or industries.

For example, if you want to invest in the wider U.S. economy, but you don’t want to pick specific companies yourself, you can instead choose an index fund linked to the top 500 performing stocks, in the shape of the S&P 500.

Index funds are not limited to just stock market tracking. On the contrary, a full range of financial instruments now allow you to invest in virtually any asset class that presents value. This also includes commodities such as Gold, Silver, Oil and Wheat, interest rates and even the legal marijuana industry!

Without investing in these hard assets via an index fund, you would only be left with two options. Either you choose individual companies that are involved in the space, or not so simply, you actually own and hold the physical assets themselves.

Therefore, index funds offer you exposure to your desired marketplace with ease.

In our ‘Best Index Funds’ guide, we are going to list four funds in particular that we think you should consider further. Whilst it will be beyond the remit of this guide to discuss each and every type of index fund, we’ll cover a mix of different markets so that you can find the right fund for your individual needs.

Before we get started, let’s quickly explore how an index fund works.

How Does an Index Fund Work?

In the vast majority of cases, the concept of an index fund is to track a particular marketplace. For example, let’s say that you wanted to invest in leading technology stocks such as Apple, Microsoft and IBM, alongside many others.

Instead of having to individually choose and subsequently purchase the stocks, you could instead use an index fund. Your chosen index fund will then track the individual prices of each stock, and create what is known as a ‘Weighted Average’.

This weighted average is what constitutes the price of the underlying index fund, much in the same way that an individual stock price rises and falls in value. However, most index funds are not as simple of this, insofar that different levels of weight are applied to certain constituents of the index fund.

In layman terms, this means that based on the fund’s internal weighting system, some stocks might contribute more to the average value of the index in comparison to other constituents.

Fidelity International Review

Read: Fidelity Review

One such example of this is the Dow Jones Industrial Average, which gives more weighting to companies that have a higher share price, even if their overall market capitalization is lower that other companies in the fund.

On top of taking the specific weighting average system in to account, you also need to consider how much the index fund charges for their services. As the purpose of the fund is to track prices, as opposed to actively picking stocks, fees should be somewhat minimal.

Each fund will need to display their fees in the form of an expense ratio, which in effect, should give you the total fees charged as a percentage rate.

So now that you have a firm idea as to how index funds work, let’s take a look at our first pick from our list of ‘Best Index Funds’.

S&P 500 Index Funds

Read: The Best S&P 500 Index Funds: Complete Guide

Pick 1: S&P 500 – Vanguard 500 Index Fund Investor Shares

The Standard & Poor’s 500 Index, or simply the S&P 500, is often regarded as a hallmark indicator to the multi-trillion dollar U.S. equity market. The underlying objective of the S&P 500 is to track the value of the 500 largest companies trading in the U.S.

Based on market capitalization, companies are taken from both the New York Stock Exchange (NYSE) and NASDAQ.

The S&P 500 offers one of the best mechanisms to back the U.S. stock markets in their entirety, not least because you are diversifying your risk across 500 companies across multiple industries. Without such an index, you would need to individually back all 500 companies, which would not only be complex, but costly too.

There are a range of index funds that will allow you to track the movement of the S&P 500, however for the purpose of our guide we have decided to opt for Vanguard.

The Vanguard 500 Index Fund Investor Shares is one of the most established of its kind, dating all the way back to 1976. In order to track the S&P 500 with the highest degree of precision, Vanguard actually purchase the individual company stocks.

Not only this, but to ensure that the fund mirrors the official index to the best of its abilities, Vanguard use much of the same weighting averages as displayed by S&P themselves.

In terms of the underlying fees, Vanguard are also one of the best priced, coming in with at an expense ratio of just 0.14%.

Pick 2: FTSE 100 – HSBC FTSE 100 Index Fund

The Financial Times Stock Exchange 100, or simply the FTSE 100 or ‘Footsie’, is an index that tracks the largest companies listed on the London Stock Exchange, based on market capitalization. Much like in the case of the S&P 500, the FTSE 100 is an excellent indicator of the wider economy, and it subsequently allows you to diversify your risk levels.

Once again, there are a range of individual funds that track the FTSE, although one of the best-known is that of the HSBC FTSE 100 Index Fund. This particular FTSE fund aims to match the returns of the primary index like-for-like.

In order to do so, HSBC directly invest in the companies that make up the index, by utilizing the very same weighting mechanism. In terms of fees, you will be looking at an expense ratio of 0.18%.

Pick 3: Gold – SPDR Gold Shares

As the old saying goes, Gold is king. In fact, recent evidence suggests that more and more nation states are increasing their gold supplies with the view of protecting their economies in the event of a global crisis.

On top of traditional equities, some investors like to reserve a proportion of their portfolio for hard assets such as Gold. However, for the average investor, stockpiling physical gold is not a conducive exercise.

With this in mind, there are now a range of Gold index funds that have the capacity to track the movement of global prices. These most commonly come in the form of an exchange traded fund (ETF), which essentially allows you to speculate on the price of an asset without needing to own or store it.

One of largest Gold-backed ETFs is that of the SPDR Gold Shares. One of the most important aspects to the SPDR Gold Shares fund is that it actually buys physical gold bullion. In effect, this is beneficial for the underlying tracking system, not least because ownership of the gold facilitates ultra-tight price movements.

In total, this particular fund has assets that exceeds $32 billion, with 2017 returns amounting to gains of 12.81%. At 0.40%, the  expense ratio offered is somewhat higher than the other index funds we have mentioned, however this is partially due to the underlying costs of purchasing and storing the physical gold.

Pick 4: Russell 2000 Index – iShares Russell 2000 ETF

If you have a slightly higher appetite for risk, then it might be worth considering an index fund that tracks the Russell 2000 Index. For those unaware, this particular index aims to track the performance of approximately 2,000 U.S. based companies with small market capitalizations.

However, the term small is somewhat misleading, not least because the average market capitalization for companies that make up the index is $2.4 billion. As such, these companies are still of significant size, at least with respect to smaller markets such as the Alternative Investment Market (AIM).

One of the leading tracking funds for the Russell 2000 is facilitated in the form of an ETF by iShares. Much like in the case of the other funds we have mentioned, you as an investor do not actually own the  shares. Rather, you are speculating on the movement of the index itself.

The iShares Russell 2000 Index charges an annual expense ratio of 0.19%, which is reasonably competitive when one considers the number of constituents representing the fund.

The reason that we say the Russell 2000 offers a slightly higher risk level in comparison to other stock indexes is that the underlying companies are slightly more susceptible to larger pricing swings.

However, this is countered by the fact that you are tracking the price of more than 2,000 companies. As such, it is hoped that in the long-run, and much like other stock market indexes, growth should be on an indefinite basis.

Kane Pepi

Kane holds a Bachelor's Degree in Accounting and Finance, a Master's Degree in Financial Investigation and he is currently engaged in a Doctorate - researching financial crime in the virtual economy. With a keen passion for research, he currently writes for a variety of publications within the Financial and Cryptocurrency industries.

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