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Deciding to invest in index funds and ETFs is one of the best decisions you can make as an investor. The next step is finding the best index funds and ETFs to invest in.
I’d like to say that there aren’t any bad options, but, there are.
There are many, many bad index funds and ETFs that you should avoid. Mainly, ones with high fees and expense ratios.
But fear not! We’ll walk through everything you need to know to choose the best index funds and ETFs. It’s an easy decision to make once you have the right information.
First, I want to quickly highlight the differences between ETFs and Index Funds. While I will refer to them as the same thing in this article, which they largely are, there are still some unique differences.
Index Funds vs ETFs
At a high level, most index funds and ETFs look to mirror underlying stock indexes (like the ). Index funds came around thanks to John Bogle, who was an investing pioneer and the founder of Vanguard. The average investor, like me and you, owe a lot to John Bogle for making it easy and affordable to invest in a diversified manner.
While Bogle started the first index fund, he did not create the first ETF. They are pretty similar overall, but there are some subtle differences worth pointing out.
An index fund operates like a mutual fund – they are bought and sold at the end of the trading day. There are typically no fees to purchase index funds (when buying directly from the fund provider) and no spread when making a purchase.
ETFs, or exchange-traded funds, are traded throughout the day like stocks. They also mirror an index and have low fees, but sometimes include trading fees (although, not through the best online brokers like Charles Schwab) and have a spread when making a purchase.
Let’s break down the differences between the two in a bit more detail:
Index Funds
- Trade at the end of a day
- No fee to purchase (when buying directly from the fund provider)
- No spread
ETFs
- Trade throughout the day
- Sometimes a fee to purchase (if not buying through a platform like Schwab, who waves the trading fee)
- Has a spread (although these are usually very, very low if buying a reputable ETF)
Both Index Funds and ETFs are great investment options. I would not sweat the details between the two, but rather focus on some of the areas below to help decide on the best Index Fund or ETF.
How to Choose the Best Index Funds or ETFs
Here are the four factors you need to consider when picking the best index funds or ETFs for yourself:
- Where to Buy: which brokerage account will you use?
- TypeofIndextoMirror: which underlying index fits your needs?
- Expense RatioandOtherFees: how can you minimize fees?
- Other Index Fund Basics: Minimum investments, past performance, distribution yield, etc.
1. Where to Buy
A key step to choosing the best index fund is deciding where to buy your fund.
Charles Schwab and Vanguard and two great brokers who have a wide variety of good options when it comes to index funds. It’s why they’re both fan favorites in the investing community.
Charles Schwab: Personally, I use Charles Schwab for my index investing needs. You can learn more about how to get started with Schwab here.
Picking a broker is so important because you’ll oftentimes be limited to buying the funds that your broker offers.
Sure, you could buy a Schwab fund from your Vanguard account, but that will cost you. Buying within your current broker is the best way to keep costs down.
For example, buying a Schwab ETF through Charles Schwab costs $0, but through any other broker you would (likely) have to pay the $5-7 transaction fee.
If you’re buying through a 401k, you might be forced to use a certain fund family. For example, my 401k is through Fidelity. I have limited fund options, but I make the best selection out of what is made available to me.
Bottom Line: Find a broker or family of funds who offer strong options (like Schwab or Vanguard), and buy through them to ensure the lowest transaction costs.
2. Type of Index to Mirror
The types of indexes have grown in recent years, and this is where many investors can quickly go wrong when building their portfolio.
At a high level, there are stock index funds, bond index funds, and others as well.
The best funds are often the simplest and mirror established indexes like the S&P 500, total International Stock Market, or Small-Cap stocks. However, when you keeping niching down (to, for example, small-cap pharmaceuticals) you start to learn more towards gambling (and stock picking) and away from index investing.
So, be sure you are choosing a broad market index to mirror before making any investment decisions. Below are some broad options to consider:
- Equities
- S&P 500
- Dow Jones Industrial Average
- Total Stock Market
- Large-Cap
- Mid-Cap
- Small-Cap
- International
- Emerging Markets
- Bonus Consideration: Equal Weight Index Funds
- Bonds
- Total Bond Market Portfolios
- TIPS (Treasury Inflation-Protected Securities)
- REITs (Real Estate Investment Trusts)
Bottom Line: Avoid anything that is too specific, and focus on picking funds that mirror established indexes (like the S&P 500 index) or have a long track record of success (like small cap equity stocks).
3. Expense Ratios and Other Fees
There are a few types of fees and expenses to keep an eye on. You want all of them to be as close to $0 as possible (if not $0).
Expense Ratios
Expense ratios are the ongoing percentage of your dollars that the fund takes for any operational, admin or miscellaneous costs.
With actively traded mutual funds, expense ratios can be as high as 1% ($100 for every $10,000 invested, every year). With index funds, expense ratios can be as low as 0.03% ($0.03 for every $100 invested, every year). Or, in some cases, even 0%!
You should aim to find funds with extremely low expense ratios.
The below chart provides a great example of why this is important. All else being equal, a $10,000 investment in a low expense ratio fund (0.05%) grows to be $40,000 more than a high expense ratio fund (1%).
One great reason to avoid actively managed funds that come with a high expense ratio.
Load Fees
Load fees (either front end or back end) are sales commissions charged from the fund family when you buy or sell the fund.
They should be $0.
No questions asked.
Spreads
Spreads apply to ETFs because they trade like stocks.
There will be an asking price (what you pay to get the ETF) and a bid price (what you receive when you sell the ETF). The spread between those two prices is what goes to the middle man who helps facilitate the trade (and it’s a cost to you).
It’s like on ebay where if you sell something for $40, you might only get $38. That’s because ebay takes a cut, just like the middle man does here.
This cost should only be a few pennies. If it’s more, I would rethink the ETF you are looking to purchase because it is a likely a niche ETF without a lot of trading volume.
Transaction Costs
This would be the cost your broker charges to make the trade. If you’re trading Schwab funds through Schwab, this would be $0, but at most other reputable brokers it should be no more than $5-$10 per trade (if not $0).
12b-1 Fee
Apparently there is another fee that funds like to charge to cover sales and advertising expenses. Watch out for this, as it should be $0.
BottomLine: Minimize fees! You can see how these fees quickly add up. So, aim for load fees, transaction costs, and 12b-1 fees to be $0, and aim for expenses ratios and spreads to be as low as possible. This will keep more of your investment in your pocket.
4. Other Index Fund Basics
Overall, if you are selecting funds that mirror an established index and are low in fees, you’re in great shape.
If you want to conduct even more due diligence, here are a couple of other factors to keep in mind when choosing the best index funds and ETFs.
Minimum Investment
Some index funds have a minimum initial investment that they require. Before researching them too much, you’ll want to ensure you have enough money to fulfill the minimum.
Additionally, some funds have a minimum investment before they provide you with their lowest fees.
For example, with Vanguard, you get a lower expense ratio on some of their admiral funds if you invest the minimum of $3,000. If you are just starting to invest and have minimal funds to contribute, this is a good measure to keep an eye on to avoid paying fees early on.
Past Performance
If you are investing in an index like the S&P 500, this is usually known as it’s broadcasted every day on the news.
However, some bond funds and international funds have shorter and less understood historical performances to examine. It is good to understand historical performance before jumping into any investment (as its usually the best indicator we have of future performance).
Distribution Yield
This is what percentage of the fund value that will be paid in the form of dividends (or fixed income payments). This is your guaranteed* return on the year and one reason why many folks like dividend investing.
*Guaranteed as long as the underlying stocks do not change the percentage yield (among other factors), which they can.
Actively Managed
A good double-check that you are truly buying an index fund is to make sure it is not under active management. Paying a fund manager extra money to pick stocks is the antithesis of an index fund investor!
The Benefits of Index Funds
The list of index fund benefits is long, especially when you are following some of the info above and picking the best index funds for you.
Diversification
As mentioned at the beginning of this article, Bogle, the founder of index funds, made it easy for investors to diversify.
That is because, with index funds, you don’t have to pick hundreds of individual stocks to diversify your portfolio. Instead, you can do so with just one or a couple of top index funds.
Low Fees
Sure, mutual funds are great diversification tools as well, but they are usually more expensive thanks to their high management fees.
Index funds don’t have managers to pick stocks, they simply follow the underlying index they are meant to mirror. This keeps costs low and more money in investor’s pockets.
Simplification
Last but not least, index funds and ETFs are simple to purchase and manage.
one of my favorite investment strategies is to create a 3 fund portfolio. This involves buying just three funds to create a balanced index portfolio:
- Bond index fund
- Domestic equity fund
- International equity fund
The asset allocation between the three funds then depends on your risk tolerance and stage in life. You will likely be more conservative as you near retirement.
Cheat Sheet: List of Index Funds and ETFs
Charles Shwab:
- SWTSX– Schwab Total Stock Market Index Fund (0.03% expense ratio)
- SWISX– Schwab International Index Fund (0.06% expense ratio)
- SWAGX– Schwab U.S.Aggregate Bond Market Index Fund (0.04% expense ratio)
- SCHB –Schwab U.S.Broad Market ETF (0.03% expense ratio)
- SCHF –Schwab International Equity ETF (0.06% expense ratio)
- SCHZ– Schwab U.S.Aggregate Bond ETF (0.04% expense ratio)
Vanguard:
- VTSAX– Vanguard Total Stock Market Index Fund (0.04% expense ratio)
- VTIAX– Vanguard Total International Stock Index Fund (0.11% expense ratio)
- VBTLX– Vanguard Total Bond Market Fund (0.05% expense ratio)
- VTI– Vanguard Total Stock Market ETF (0.04% expense ratio)
- VXUS– Vanguard Total International Stock ETF (0.09% expense ratio)
- BND–Vanguard Total Bond Market ETF (0.05% expense ratio)
Have any questions about choosing the best index funds and ETFs after reading this? Reach out or comment below.
There are a lot of great ways to start your investing journey today, including:
- Checking out our 5 steps to get started today
- Getting your free analysis with Blooom to see if your 401(k) is set up optimally and matches your investment strategy
