Everything You Need to Know About Index Funds

By Markets Fool.com

Perhaps the only certain thing in investing is that index funds will continue to take the lion's share of new investment capital coming into the stock market. From 2009 to July 2016, passive index funds grew in every single year as investors added more money to low-cost funds. Meanwhile, active funds have experienced outflows, as investors pull cash out at a faster rate than new cash is invested into them -- and the pace of outflows is accelerating.

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On this edition of Industry Focus: Financials, join The Motley Fool's Gaby Lapera and Jordan Wathen as they discuss everything you need to know about investing in index funds, why they're so popular, and why they may be a great investment for your retirement portfolio.

A full transcript follows the video.

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This podcast was recorded on Sep. 14, 2016.

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Gaby Lapera: Hello, everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You arelistening to the Financials edition, taped todayon Wednesday, September 14th,2016, but you are listening to this onOctober 3rd. Happy October. My name is Gaby Lapera, and joining me on Skype is Jordan Wathen, ananalyst in our financials bureauhere at The Motley Fool. Hi, Jordan. How's it going?

Jordan Wathen: It'sgoing well, how about you?

Lapera: Awesome,I'm glad to have you on the show today. Today, we aregoing to attempt to answer a listener questionfrom Abrielle Elise. Shewould like to know how to purchase an index fund. There's a lotthat could potentially go into that. I decided tomake it enough to have an entire show. Getready to learn all about index funds. Jordan,I'm going to start with an extremely softball question. What is an index fund?

Wathen: Anindex fund is, technically speaking,any kind of fund that invests in an indexand isn't actively managed. An actively managed fund hiresportfolio managers and analyststo find good stocks and bondsthat they think will make great investments,and they generally seek to outperform the market, or outperform a benchmark. Index funds,on the other hand, they just buythe index. If you buy a traditional S&P 500index fund, likeVanguard's 500 index fund,it buys and sells all the stocksin the S&P 500. That's all it does. If a stock is removed from the S&P 500, then the fund sells it. If a stock is added to the index, then the fund buys it.

Lapera: Just for ourlisteners, in case you haven'tcaught on to this,there are these things called indexes,and they work just like an index in a book. They list everything that's in the book. The index listseverything that's in that particularindex, stock index, which is whyit's called the S&P 500 Index.

Wathen: Right. TheS&P 500 Indexgenerally holds 500 of the largestcompanies in the United States, or that trade on U.S. markets.

Lapera: Right. You weretalking earlier about mutual fundstrying to beat their benchmark. Typically The benchmark issome kind of index.

Wathen: Right,typically it is an index. It depends. Bonds have bondindexes, bond investors aren't trying to beat stocks. Andstock investors would hope that they could outperform bonds, generally, but they're not benchmarked to bonds.

Lapera: Can you name any othermore commonly knownstock indexesfor our listeners?

Wathen: TheS&P 500 is a large-cap index. It holds 500 of the largest stocksin the United States. On the other end of the spectrum would be, say, theRussell 2000, which holdssmall-cap stocksin the United States.

Lapera: Just so our listeners know, cap refers tomarket capitalization. A large-cap stockwould be a company whose market capitalization is above $5 billion. Of course, that figure variesdepending on who you ask. But around $5 billion is good enough for our purposes. Small cap is,obviously,a lot smaller. When I say a lot smaller, I mean, say, $200 million. It's a lot, lot smaller.

Second question,why would you want to invest in an index fund?

Wathen: Theprimary benefit of anindex fund isbecause they don't employ managersto oversee the portfolio andhire very expensive analysts to go findstocks or bonds for it, stocks and bonds they think will be good investments. They can pass on those much lower costs to investors. There's a group out there calledtheInvestment Company Institute,and they basically collect information on theworld of investment funds. In 2015,the average stock mutual fund charged anexpense ratio of 0.8%. That's an actively managed fund, 0.84%. Now,index funds, on the other hand, cost0.11%in 2015 -- roughly 1/8 the cost for an index fund compared to an active fund.

Lapera: That's a huge amount. I realized thatwhen you're talking about anything that's preceded by zero point something, itdoesn't seem like it would make a huge difference. But if you spread that amount out over time, you're losing a lot of money in fees.

Wathen:Right.I just did it, but I hate when people put it in perspective of --the amount of assets under management,put it into consideration ofthe average return over time. Let's saythe S&P 500'saverage return might be 8%; we'll justgo with that figure. If you pay 0.8%, you'rebasically giving up 1/10 of your return. If you pay 0.1%, you'regiving up 1.25%of your return. It's an astronomical difference.

Lapera: It's huge. So,it's really important to look at expense ratios, which issomething that we'll actually get to in a little bit. I think we've kind of touched on this, but an index fund can be a mutual fund or an exchange traded fund,because it's literally any fund that tracks an index. So it just depends onhow you're buying it. We'll geta little bit more into that,because it gets into the costs.

Theother reason why you might want to have an index fund ismaybe you don't have a lot of timeto pay a lot of attention to the stock market,but you would like your money to still continue growing. So you can just put your money into an index fund and let it grow passively. It's generally a much better placeto keep your money and have it continue growing than a savings account,because at least it will keep pace with inflation,and perhaps exceed it a little bit,if it's doing what it's supposed to do. Basically, that sums up thatpassive investing is fun if you don't have a lot of time. The other thing that'sreally good about index funds is diversification.

Wathen:Right. Diversification, after costs and being a passive investor,it's one of the biggest benefits. To use an example,there's an index out there and it's very popular. It's calledthe Total Stock Market Index. It basically tracks every single stock in the United States that's a practical size to actually own. Vanguard's Total Stock Market Index for the United States holds more than 3,600 stocks, which is extreme diversification. The only stocks it voids are stocks with market caps, or market values, of less than $10 million, which are really just stocks that are too small for the fund to even hold, or buy and sell out of. To put that in perspective, there's this website out there where you can basically buy and sell private companies, and I've seen car wash chains sell for more than $10 million. At that valuation, you're not missing out on much. It's basically the stock market, the whole thing -- 99.9% of it.

Lapera: Yeah. But if you want to get a little bit more specific than that, you can be, like, "I want to invest in a consumer goods index fund, and it's an index fund that tracks consumer goods companies."

Wathen:Yeah. There's a new ETF that came out recently. It's technically an index fund because it tracks an index, and it trades under the ticker symbol SLIM. Itactually tried to invest in companies thatwould make money on the growing obesity problem. So, these can get extremely specific.

Lapera: That'scrazy. That's a very clever ticker symbol.I always get a chuckle out of some of them. That's really smart,I'll have to look into it. Basically, diversification is the opposite of having all your eggs in one hand basket. You basically have one hand basket for every egg you've ever bought in your entire life, which keeps them all gently padded and safe. Of course,diversification, moving on to our next topic, can be a disadvantage. For example, say that you boughtApple (NASDAQ: AAPL)in 1990 when it was still really cheap. Right now,you would have a lot of money. Butif you invested in an index fundthat Apple was a component ofin 1996,you would still have more money than when you started,but you wouldn't have as great of a returnas you would have with solely having just invested in the index fund than you would have if you had just invested in Apple.

Wathen:Right. Andsome people call that "diworsification," which is a play ondiversification. But if you think about the legendary investors of the world, like Warren Buffett, he wouldn't be anybody today if you made him go buy 1,000 stocks. No one would even know his name, if he had to, in a given time, own 1,000 stocks. Not that his returns would have necessarily been good or bad, butWarren Buffett made a fortune because he was superconcentrated into his best ideas. If you buy an index fund, by definition,you are rarely, if ever, super invested in one or two or three or 10 companies.

Lapera: Right. So whilediversification insulates you from acompany going completely broke,because there's so many other companies that are doing fine in the index,but it also insulates you from making mega profits that you couldif you picked one stock, in particular. For reference, I think Warren Buffett has around 50ish stocks in his portfolio right now, which is not a lot,especially considering that he has an entire investing teamfiguring out what to buy. He could have a lot of stocks.

Wathen:Right,especially considering his big four makeup. I don't know the percentage offhand, but it's a verysignificant percentage of that amount.

Lapera: Yeah. Theother thing we talked about earlier is fees. This is somethingthat you have to take into account when you're buying an index fund. The other thing you need to keep in mind when you're buying index funds, at least as an ETF, is that you are probably going to have to pay a commission.

Wathen:Right. And really, this goes for any fund, whether it's anexchange traded fund, or even a mutual fund, a mutual index fund, is that you will probably have to pay a commission. Some companies offer commission-free trades. Some brokerage houses do. But in general, those tend to be the higher expense ratio funds, so be careful with that, as a general rule. Especially with exchange-traded funds, because ETFs are bought and sold like stocks on the stock market. You have to pay a commission,just like you would if you bought and sold shares of Apple.

Lapera: Yeah. Andthe final disadvantage related to diversificationis that you are never going to outperform the market. Bydefinition, you can only do as well as the market does. Lucky for you,the market, historically, has always risenover time, even if there are some giant dipsin the intermediate,in the short term. But you're nevergoing to get a huge winner of a stock by investing in an index fund, which means you'll never have thesatisfaction of rubbing it in your boss' face when your stock picks outperform his. Heh.

Wathen:Andthat's not such a bad thing. Wedon't want to scare people away from this. Theaverageactive stock picker isn't going tobeat the market anyway after costs.

Lapera: That is super true.

Wathen:So take that into consideration.

Lapera: Yeah. In fact, the averageactively managed mutual fund is also not able to beat an index fund.

Wathen:Right,exactly.If Harvard MBAs can't do it,then you can't be too upset about it.

Lapera: I think it's something like, only 20% of mutual funds outperform their benchmarks. Something absurd, like 80%, do not. Keep that in mind. Let's get to the nitty-gritty ofactually buying one. There are fees involved inbuying an index fund. We mentioned the commission, if you're buying an ETF, but that's the same as if you're buying any other stock. There's also purchase and redemption fees. Can you get a little bit into those for me, Jordan?

Wathen:In the past, there used to be these fees called loads,and they've gone by the wayside. Basically, what a load was was an upfront fee,and sometimes a back-end feethat you would pay to buy or sell a mutual fund. Eventually,people figured out that paying 3%just to buy a mutual fund was a bad idea, andluckily, the world is changingand people are becoming more cognizant of cost,so they're going away. But purchase and redemption feesstill exist. You just want to be really aware, reallycognizant of the fact thatthere can be purchase and redemption fees on some funds. Even Vanguard, which is known for keeping costs as low as possible, charges some purchase and redemption fees on some of its bond index funds, for example.

Lapera: Yeah. What you would belooking for in the text --because whenever you buy an index fund,you can go online andthe companies are required to provide you a lot of information about them. Or if you really want to, you can ask for a paper copy of this. Butthere should be something that says load or no load, and you're going to be looking for a no load fund.

Wathen:Right. Even no load funds can have purchase and redemption fees.

Lapera: ... andthose will also be listed, as well. So make sure to look at that. And the other thing thatwe touched on earlier isexpense ratios. If you happen to be buying it as a mutual fundinstead of as an ETF, you want to see how much the expense ratio is. It still matters for the ETF, but a little bit less.

Wathen:Basically, what that does -- to give an explanation -- theexpense ratio is the cost of holding that fund over a yeardivided by how much you've invested in. If you have $1,000 to invest, and the fund charges 0.5% to invest in it, you'd basically be paying $5 per year on that amount.

Lapera: Right. That's a really big thing you should check before you actually buy the fund, what fees are involved. Just to refresh, again, just in case, for whatever reason, you missed it -- it's purchase and redemption fees, whether or not it has a load, and the expense ratio.

Theother thing you want to look at is, what are they actually invested in? Are youinterested in investing in the S&P 500? Are you interested in investing inutilities? Are you interested in investing in only certain market caps? There's so many different options,like Jordan mentioned.That's the first thing -- what are you actually investing in if you buy this? And again, thecompanies are required to say what is actually inside the fund. I don't know if they actually list specific companies,but most of the time, they'll tell you, at least,what sectors they're invested in.

Wathen:You can get a list; usually they'll provide a listwith specific companieson their website. But more importantly, I would say to go to the website and click on what's called a summary prospectus,and that's basically a shortened version of everything you need to know. They're still long documents that can be 20-30 pages. Butthere will be a point in that prospectus where it will say, "This is the index fund we seek to track," like the S&P 500, "and this is how we do it." The S&P 500 tracking fund would buy all the stocks that are in the S&P 500, for example.

Lapera: Right, it's basically a mission statement. That's the second thing, after fees, that you should look for. Andthe other thing to keep in mind is that index fundscan have different strategiesfor how they invest. The most common one is market cap-weighted versus equally weighted funds. Doyou want to talk about that a little bit, Jordan?

Wathen: Basically -- we'll go to theS&P 500, because I think it makes a great example. The S&P 500is a market-cap-weighted index. So the largest company in the S&P 500, which happens to be Apple, makes up the largest share of theS&P 500. The smallest companiesmake up a much smaller share of it. So when a traditional market-cap-weighted index fund buys into the S&P, they put about 5% into Apple, and then I think it'sExxonMobilorMicrosoftthat's next,I can't remember. But they'll be 4.7%, andit just goes down the list until you get into fractional percentages. On the other hand, an equal-weighted index will basically take the 500 companies that are in the index and divide the money equally between them. So you have 0.2% of your money invested in every single stock if you bought an S&P 500 index fund.

Lapera: Right. It'sup to you whether or not this matters to you. If you do an equal-weighted fund... it's up to you, really. If you feel there's a huge difference, then that's something you should keep in mind.

Wathen:Yeah. The biggest difference is, an S&P 500 fund that is market cap-weighted will have more invested in the largest companies, so it'll be much more of a larger "mega cap" index, whereas an equal-weighted cap one will have just as much invested in the smaller and mid-caps in the S&P 500. A mid cap would be equal to a large cap like Apple in an equal-weighted fund, whereas in the market-cap-weighted fund, Apple will be significantly larger than the smallest companies in there.

Lapera: That's true. So depending on the index, if you end up with equal weighted,you have a potentialfor slightly more return,becauseit's easier for a smaller company to grow than for a large company to grow. Of course,the opposite is also true, it's easier for a small company to go out of business than it is for a bigger company to go out of business. So I don't know, it's up to you. That one is really 100% up to you.

The next thing that you need to do -- you'vefigured out what the fees are, you'vefigured out what the index fund is actually invested in, and you've decided, "I want to buy this index fund." The first thing you need to do is make sure you have a brokerage account.

Wathen:Right,you need to have a brokerage account. At least, if you're buying a mutual fund, you can go to the fund company. Vanguard has --I'm just using them as an example --brokerage accounts, and they have mutual-fund-only accounts. Thedifference is that a brokerage account can buy stocks in that account, whereas the mutual fund only,you can only buy mutual funds. But yes, you need to have a brokerage account. And ideally, if you're doing this, you should probably do it in a retirement account, an individual retirement account.

Lapera: If you don't know this -- in mostretirement accounts, and I'm struggling just thinking of one where you can't,you can buy stocks or index funds within the retirement account. For example, if you have an IRA, you have a total contribution limit for the year of $5,500, that's among all your accounts, total, and you can have that money just sit there. That's an option, or you can invest it into a stock or index fund -- really, whatever your heart desires.

Wathen: The important thing to remember is that you can have multiple IRAs. If you want to open an IRA withFidelityand buy a Fidelity fund or a Fidelity index fund, you can do that. If you want to open an IRA also at Vanguard, you can do that, too. The only limits on IRAsis not how many accounts you have, it's only the amount that you contribute to it each year. I don't think a lot of people are aware of that.

Lapera: Right. So you can either get it from a brokerage account -- say you have abrokerage account with Fidelity,you can buy it in a retirement account. The other option you mentioned was, you can buy it directly from a company -- so,you open a brokerage account with the company. So let's doVanguard again, because it's my favorite. We'll cover that. I'm not advocating that you buy it just because it's my favorite later. Anyway, say you want to open aposition in an index fund from Vanguard. You can open one with Vanguard. Most companies actually allow you to buyindex funds from their competitors, anyway. So if you wanted to, you could open an account withVanguard, and then also buy a Fidelityindex fund from your Vanguard account.

There are a couple things youneed to make sure of. Youoften get dividends fromthese index funds. You should set up something called a DRIP plan, which is a dividend reinvestment plan. I prefer having my dividends automatically reinvested. So instead of getting a checkevery month, I just have that automatically reinvestinginto the fund, and you can get a fractional share. But the one thing you really want to make sure with that is that you don't pay a commission every time the dividend gets reinvested.

Wathen:Right. Togive an example, the S&P 500,I think the yield on it right nowis somewhere around 2%. If you invest, say, $5,000 into an S&P 500 fund, you will havedividend distributions of probably of about $100 over the next year. To reinvest that and pay a $10 commission on it is just insane. That's 10% off the top,and it really adds up over time. That's why I would recommend for the average person -- andI hate saying this becausefinancial advice is so individual-- theaverage person is probably better off in an index mutual fund versus anexchange traded fund, because mutual funds generally have no or low commissions compared to ETFs.

Lapera: Yeah. Ifyou are wondering whether or not your fund charges you a commission every time you use your DRIP, you justneed to check the paperwork. They are legally required to disclose all of this to you. In terms of actually how to purchase one step by step,it's difficult to say, because everyone's brokerage accounts look different. But somewhere, there should be a box that lets you type in a ticker,and a button somewhere that says buy. Make sure you have enough funds in your account, and make sure that you're aware of all the things we talked about ahead of time. Do you have any last advice for how to buy an index fund, Jordan?

Wathen:The thing is,every brokerage firm isdifferent, so I can't say, "Go here and click this," and have you buy it. I would just say, if you have any doubt whatsoever, just give them a call. The only thingbrokerages really do anymoreis provide customer service. Anyone can execute a trade today, it's not a big deal. But really, if you're going to pay them fees, you should make use of the customer service -- justcall them up and ask, honestly.

Lapera: Yeah, that's great advice. So just to sum up, index funds, it's not cool but they work.(laughs) Make sure you check for fees. Make sure you know what you're actually investing in. And know what the pros and cons, in general, of the index funds are. In case you missed it,there's the whole first half of the episode, just rewind.

Thanks so muchfor joining us!I hope you guys are having a great October. If it's October 3rd,I'm either in San Francisco or Beijing. Hi from abroad, or potentially, the other coast!As usual , people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus. If you have any questions about this episode,I probably won't answer it, but someone else will,unless you're listening to this episode next year, in which case, I personally willprobably respond to it. Thank you to Austin Morgan, who loves diversification, today's awesome producer. And thank you to you all for joining us. Everyone have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of ExxonMobil and Microsoft and has the following options: long January 2018 $90 calls and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.