Investing 101: Understanding Index Funds

index funds
29
Sep
index funds

Understanding Index Funds

There’s a lot of ways you can get involved in securities investing. Some of the most popular methods are through the use of what are called index funds. An index fund is a type of mutual fund that tracks the performance and returns of a market index.

You are probably familiar with stock and security market indexes like the S&P 500 or Russell 2000 index. Because a market index essentially acts as a barometer to track and project returns for a collection of similar securities, you are not able to directly invest in them. However, since index funds seek to track the returns of market indexes, you are able to use them as a sort of indirect investment channel.

How Index Funds Work

Typically index funds operate in one of two different ways:

  • the fund will invest in all of the securities in a single market index
  • the fund takes a sampling of available securities for an index

The value of securities included in a market index is determined either by a company’s market cap or by its price-per-share.

Traditional vs. Non-Traditional

While most index funds seek to track market indexes, there are other types funds that use complex or custom-built indexes to select investments. These are known as non-traditional index funds. You may find them more suited to your individual investment goals than a traditional fund.

Does an Index Fund Work for You?

Most index funds follow a passive rather than active investment plan. They are most often utilized by investors looking to maximize long-term returns.

This also means, in most cases, that an index fund has less costs and fees associated with it than an active investment account. Due to their passive nature, fund managers need to devote less hands-on time and resources than active funds.

Associated Risks

As with any form of investment, there are associated risks. Understanding these risks can go a long way in helping you mitigate them early on.

In general, index fund securities are subject to the same risk factors as the market index it tracks. There are also other risks of which you need to be aware:

  • An index fund may have less flexibility than a non-index fund. It may be less apt to accommodate price declines in the securities it tracks.
  • The tracking of the index fund may not be accurate. For instance, if a fund only tracks a sampling of available securities in a market index, it is not representative of the entire index.
  • The index may underperform due to any of the above reasons. It also may underperform if subject to excessive fees and costs.
Know Before You Invest

Before you decide to invest in an index fund, make sure you have a clear understanding of not only what securities the index fund tracks, but also the associated costs and fees. You’ll also want to make sure the fund manager or financial professional offering the investment is properly licensed and in good standing.

Here are some common questions you should be asking – both about the fund itself and the fund manager:

Questions about the investment
  • Is this investment product registered with the SEC or my state securities agency?
  • Does this investment match my investment goals? Why is this investment suitable for me?How will this investment make money? (dividends? interest? capital gains?) What could cause this investment to increase or decrease in value? (for example, changes in interest rates, real estate values, or market share?)
  • What are the total fees to purchase, maintain, and sell this investment?
    • Are there ways that I can reduce or avoid some of the fees that I’ll pay, such as purchasing the investment directly?
    • After all the fees are paid, how much does this investment have to increase in value before I break even?
Questions for your financial professional
  • Are you registered with our state securities regulator? Have you ever been disciplined by the SEC, a state regulator, or other organization (such as FINRA) or one of the stock exchanges?
  • How long has your firm been in business? How many arbitration awards have been filed against your firm?
  • What training and experience do you have? How long have you been in the business? What other firms have you been registered with? What is the status of those firms today?
  • Have you personally been involved in any arbitration cases? What happened?
  • What is your investment philosophy?
  • Describe your typical client.
    • Can you provide me with some names and telephone numbers of your long-term clients?
  • How do you get paid? By commission? By the amount of assets you manage? By another method?
  • Do I have any choices on how to pay you? Should I pay you by the transaction? Or a flat fee regardless of how many transactions I have?
  • Do you make more if I buy this stock, bond, mutual fund, or ETF, rather than another? If you weren’t making extra money, would your recommendation be the same?
  • Are you participating in a sales contest? Is this purchase really in my best interest?
  • You’ve told me what it costs me to buy this stock, bond, mutual fund, or ETF; how much will I receive if I sell it today?
  • Where do you send my order to be executed? Can we get a better price if we send it to another market?
  • If your broker changes firms, ask: Did they pay you to change firms? Do you get anything for bringing me along?

Additional Investor Resources

As you may have noticed, many of the above questions have universal applications in the investment world. You should always be doing your due diligence when it comes to investment decisions, regardless if it seems like a safe bet or not.

By not asking questions, you subject yourself to unnecessary risks like fraud that can be devastating to your portfolio.

If you’ve been the victim of securities fraud or stockbroker misconduct, contact our team.