5 Tips for Choosing the Best Index Funds - dummies

5 Tips for Choosing the Best Index Funds

By Russell Wild

Part of Index Investing For Dummies Cheat Sheet

When you’re ready to invest in index funds, get ready to do some research. Selecting from roughly 300 index mutual funds and over 700 ETFs (exchange-traded funds) can be daunting. Where do you start?

  • Start with the type of investment that you need for your portfolio. If you need long-term growth, you want stocks. If you need stability, you want bonds. If you already have a portfolio of one or the other, you should be looking to balance that off. Within these two large categories of stocks and bonds you want diversification. You want both U.S. and foreign stocks, and you want both large-company and small-company stocks.

  • Decide whether you want an index mutual fund or an exchange-traded fund (ETF). This is a secondary issue but still important. ETFs may have lower operating expenses but cost a few bucks to buy and sell. They are often your best option for long-term, buy-and-hold, no-touch-or-tinker investments, but not your best option for accounts where you are making regular contributions or withdrawals. If you’re investing in a taxable account, the ETFs may be slightly more tax efficient.

  • Always look to the bottom line. If you decide you want, say, an ETF that mirrors the S&P 500, you’ll find a good number of possibilities, even though all the funds will be pretty much the same. Immediately rule out all of the load funds, and be sure to compare annual operation expenses.

  • Examine the index behind the scene. A solid house rests on a solid foundation, and so does a solid index fund. The foundation is the index itself, whether that be the S&P 500 or any number of lesser-known indexes.

  • What about returns? An index fund will do as well as the index it represents, minus the expenses of the fund. Stocks can be expected to return more than bonds over the long run (with greater volatility.) Small cap stock funds can be expected to perform better over the long run than large cap stock funds (also with greater volatility).

    Long run means many years, so don’t be overly concerned with what an index fund has returned in the past months or even in the last year or two. Such numbers are largely irrelevant. Most investors jump into hot sectors . . . often as those sectors are just about to cool. Resist the urge to chase high returns.