If you have any connection to the personal finance community, then you have probably heard of index funds.
Why is this generation so passionate about index funds?
Well, one reason might be because the majority of today’s adults witnessed the stock market crash of 2008.
We heard about retirement accounts that were wiped out, stock values that dropped to zero and other financial tragedies.
As a result, some of today’s young and middle-aged adults have adopted a more conservative risk tolerance.
For these (somewhat) conservative investors, index funds nicely fit into their tolerance level.
Like any investment, index funds are subject to risks, however, their asset diversification and historical performance put certain investors at ease.
According to Index and ETFs by David Schneider-
“The [index fund industry] holds almost a quarter of all US household financial assets and 60% of all the money in individual retirement accounts – and the trend is upwards.”
So, what are index funds?
Let’s break down a few definitions before we get into the deets.
Definitions
- Market Index – A market index tracks the performance of a “basket” of securities, which is meant to represent a sector of a stock market, financial market or other asset market. Examples include the Standard and Poor (S&P) 500, the Russell 2000 Index and Nasdaq Indexes.
- Index Funds – according to the SEC, an index fund “seeks to track the returns of a market index. ” Some compare an index fund to an aisle of goods in the grocery store; while a stock is comparable to a single good (a cereal box, jar of honey, etc.) on that aisle.
- Index Mutual Funds – An index mutual fund is an index fund that is managed by an SEC-registered investment adviser. This adviser typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. When it comes to buying and selling investments in these funds, investors trade directly with the fund and mutual fund prices are established at the end of the trading day. This is because they are “open-end” funds, which means they can issue an unlimited amount of new shares.
- Actively-Managed Mutual Funds – An actively-managed mutual fund has the same trading characteristics as an index mutual fund. The difference lies in its management, performance goals and underlying investments. According to FINRA, an actively-managed mutual fund “employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio…The goal of an active fund manager is to beat the market — to get better returns by choosing investments he or she believes to be top-performing selections.”
- Exchange Traded Funds (ETFs) – ETFs are products that can track an index, pool multiple investments from one sector (such as bonds, commodities, etc), or pool other like-kind assets. For ETFs that track an index, the goal is to achieve the same return as the index that they track by investing in all or a representative sample of the stocks included in the index. Unlike mutual funds, most ETFs are passively managed (there are some actively-managed ETFs) and have shares that trade like stocks on stock exchanges. When it comes to trading, ETFs are “close-end” funds with a limited number of shares that can be bought or sold at fluctuating prices throughout the trading day.
Interview with Chelsea Ransom-Cooper, CFP®
Alright, now that we have a little bit of background on index funds, let’s get answers to some frequently asked questions.
Our answers are provided by an award-winning Certified Financial Planner – Chelsea Ransom-Cooper.
Chelsea is a Managing Partner at Zenith Wealth Partners, Founder of Women With Equity, and one of the Association of African American Financial Advisors (Quad A) 50 Under 50 financial professionals.
With experience advising wealthy retirees, individuals, families and businesses, she knows a thing or two about the risks, value and strategy behind index funds.
Here is what she had to say –
1. Why are Index Funds so popular amongst beginning investors?
When it comes to investing, the hardest part is getting started.
For Beginner investors, hands-off investing is the simplest way to start.
Hands-off investing is a common strategy used to passively manage your investments. It allows you to spend minimal time monitoring and researching your portfolio.
Investing in index funds is a hands-off and passive investment strategy that can provide broad market exposure or targeted exposure to specific market segments. This is done by bundling many individual investments into a single investment.
Here are two choices you have as stock investors –
- You can purchase a single stock, or
- You can purchase an ETF based on the S&P 500 that will give you exposure to hundreds of the largest companies in the US.
For example, the S&P 500 gained 28.7% in 2021, while companies like Microsoft were up roughly 52% and Disney was down roughly 14%.
If I had Microsoft and Disney in my investment portfolio, I would read their annual filing and quarterly earnings report to ensure their growth expectations align with my goals for my portfolio.
Reading these reports requires financial analysis, calculations and decoding financial jargon. The amount of research this entails can feel overwhelming to beginning investors.
When I talk to individuals who do not have the patience or the desire to participate in this level of research, I recommend for them to look into a hands-off investing strategy.
2. In which type of investment account should you hold Index Funds?
Are you maximizing your retirement contributions?
Depending on your income, you may want to start investing with a tax-advantaged retirement account such as a Roth IRA.
If you’ve already exhausted your retirement options, then consider opening a taxable investment account.
If you already have index funds in mind or if you want to pick your own, you can get started opening your accounts at a custodian like Charles Schwab, Vanguard, or Fidelity. I personally really enjoy Fidelity’s platform since you can research and compare multiple ETFs at once.
If you want to have a more automated approach, consider opening an account at a Robo Advisor like Betterment, Wealthfront, or Ellevest.
3. What costs should someone consider before they invest index funds?
Index fund investing can minimize your transaction costs.
For almost every index fund, there is an ETF model.
Now, for those trying to decide whether to invest in a mutual fund or an ETF, keep in mind that mutual funds typically have higher fees (expense ratio) and may have a minimum to invest, while ETFs have lower fees and normally do not have minimums.
And, if you decide to use a Robo Advisor, keep in mind that they charge a small fee on top of the fees the index fund ETFs charge.
Automatic investing isn’t free!
{Learn more about ETF fees here!}
4. What are the tax implications of Index Fund investing?
If you purchase index funds within a taxable investment account for long-term growth, you can minimize your capital gains tax liability by holding on to the fund.
{Learn 4 ways to minimize your capital gains tax here!}
Frequently buying and selling securities could lead to significant capital gains that you must report when you file your taxes.
Since index funds are a bucket of several securities (stocks), you only have to report a potential capital gain when you sell the fund.
The Little CPA: Index Fund investors should also know that if an index fund holds dividend stock, interest-bearing assets (i.e. corporate bonds), precious metals classified as collectibles or any other income producing asset, that income will also be subject to tax in the year incurred.
5. Our generation values socially and sustainably responsible businesses. Are there Index Funds for impact investors?
Yes, there is the Adasina social justice index, which places a particular focus on the advancement of racial, gender, economic, and climate justice.
Key ETFs that follow this index are the NAACP Impact ETF and Adasina Social Justice ETF.
Also, we are starting to see more ETFs in regard to gender and ethnic diversity.
The challenge is getting companies to report this information so investors can assess a company’s efforts.
There are also several socially responsible index ETFs that you can choose from that can provide broad market exposure (Vanguard and iShares have several Environmental, Social and Governance (ESG) ETFs).
Once you open an investment account, you can search for socially responsible or ESG related index ETFs to include in your portfolio, like the ones mentioned above.
To guide your search, Fidelity has an excellent ETF screener which will allow you to screen ETFs for Environmental, Social and Governance factors.
If you decide to use a Robo Advisor, you can also utilize their ESG models to invest passively. Betterment and Ellevest are great platforms that create diversified socially responsible portfolios for you.
Final Thoughts
Index Funds are not a risk-free or get-rich-quick investment.
Instead, they are passive investments for investors who are planning for hands-off investing and long-term growth.
Index Funds come in all sizes, fees, models, etc., so, as with any investment, make sure you do your research to build diligent wealth.
By understanding the different types of index funds and their associated risks and rewards, you can make an informed decision about whether or not they are right for you.
Remember, always consult with a licensed financial advisor before making any major investment decisions.
Happy investing!
Chelsea Ransom-Cooper is a Certified Financial Planner and Managing Partner at Zenith Wealth Partners, a fee-only financial planning firm, and registered investment advisor. Prior to creating Zenith Wealth Partners, Chelsea spent several years as a financial planner serving high net worth families and retirees with investment portfolios upwards of $2 million dollars.
Chelsea realized that she could provide a flexible financial planning and investment management approach that inspires a more diverse clientele to take financial action before they reach retirement.
At Zenith Wealth Partners, Chelsea guides individuals, families, and business owners through the many financial decisions they face to help develop strategic financial plans that meet their present and future financial goals.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisers before engaging in any transaction.