We’ve heard of the saying “Don’t put all your eggs in one basket.”
What does that mean for index funds? Should we be investing in multiple? If so, how many?
An index fund is supposedly a diversified investment. When you buy an index fund, you aren’t buying into a single company, but rather a large number of companies.
With that in mind, could it still be beneficial to invest in multiple funds?
- How are index funds different from actively managed funds?
- What Are The Different Types Of Index Funds?
- ETFs vs. Mutual Funds
- Domestic vs. International Index Funds
- How Many Index Funds Should I Own?
- Isn’t having only one or two index funds risky?
- Should You Buy the Mutual Fund or ETF of an Index Fund?
- Expense Ratio
- Minimum To Invest
- Trading Flexibility
- Should My Index Funds Be Domestic or International?
- The 4% Rule
- Final Thoughts
How are index funds different from actively managed funds?
An actively managed fund is a type of mutual fund or ETF in which a portfolio manager attempts to outperform the market by selecting individual stocks based on their own research and analysis. The portfolio manager will often make buy and sell decisions based on their view of market conditions or the fundamentals of the underlying companies.
An index fund, on the other hand, simply tracks the performance of a specific market index, such as the S&P 500 or the NASDAQ. The fund holds a diverse portfolio of stocks that closely tracks the performance of the underlying index, and the fund’s manager does not make any buy or sell decisions based on their own research or analysis. The account is passively managed.
The main difference between actively managed funds and index funds is the way they are managed. Actively managed funds rely on the portfolio manager’s ability to pick winning stocks and time the market, while index funds rely on the market to generate returns. Actively managed funds generally cost more to manage due to the cost of research and analysis, and they also have a higher turnover rate as the fund manager tries to time the market. Whereas index funds are generally considered to be lower cost and more efficient because they simply track the performance of the underlying index and don’t require the same level of research and analysis.
Actively managed funds may actually underperform the market or the benchmark index they are trying to beat, while index funds are likely to match the performance of the index they track, but with lower fees.
What Are The Different Types Of Index Funds?
ETFs vs. Mutual Funds
First, let’s take a look at the two main types of index funds available out there for the everyday investor. These are split into ETFs (exchange-traded funds) and mutual funds.
Both ETFs and mutual funds have an expense ratio, which is the cost to invest in a managed fund. This is expressed as a percentage.
The expense ratio of index funds generally tend to have lower expense ratios due to the passive nature of management.
The manager’s role is to mimic an index such as the S&P 500 or Dow Jones Industrial Average as closely as possible. They don’t actively pick and choose which stocks to buy and sell on their own
For example, the cost of investing in the Vanguard mutual fund VTSAX is currently 0.04%.
|Asset Class||Domestic Stock – General|
|Expense Ratio as of (2022)||0.04%|
Available as an ETF (starting at the price of one share).
|Fund Advisor||Vanguard Equity Index Group|
That means for every $10,000 you invest, you pay $4 each year. For every $100,000 you invest, you pay $40 per year.
The analogous index fund for the ETF version is known as VTI, and it has a slightly lower expense ratio of 0.03%.
|Asset Class||Domestic Stock – General|
|IOV Ticker Symbol||VTI.IV|
|Expense Ratio (2022)||0.03%|
|ETF Advisor||Vanguard Equity Index Group|
That means for every $10,000 you invest in this fund, you’d be paying $3 per year. For every $100,000, you’d be paying $30 per year.
And these are very reasonable expenses. On the other hand, actively managed funds can get very costly and will often eat up much of any gains for the year.
If you want to invest in VTSAX, you’d have to open a brokerage account with Vanguard directly. If you already have a brokerage and want to stay in it, it’s likely that you’re already able to invest in VTI.
Domestic vs. International Index Funds
Furthermore, the fund types can be categorized into domestic and international index funds.
A very popular way to invest includes a portfolio of mostly U.S. stocks, followed by some international stocks, and a bit of bonds.
An example of this would be a 50/30/10 allocation of US stocks (VTSAX), international stocks (VTIAX), and bond fund (VBTLX), respectively.
This is known as a 3-Fund Portfolio or a Lazy Portfolio. Don’t be too judgmental on the latter name, though. Despite its simplicity, it is enormously effective.
How Many Index Funds Should I Own?
There is no perfect number, and it depends heavily on your personal circumstances. However, owning many is usually overkill. One or two funds do the job just fine.
Consider VTSAX: Over 3,900 different companies make up the fund. That includes the majority, if not all of the S&P 500 companies, and the S&P itself is already regarded as a well-diversified unit.
If the S&P is a broad market index, then VTSAX would be a total market index effectively. And it actually is, since it follows the CRSP U.S. Total Market Index.
Of course, the tail-end companies have smaller market caps, so it isn’t precisely eight times the size of the S&P, but the diversification is still impressive.
These two indexes perform exceptionally close to each other, and if one outperforms the other, it’s a minute difference. You can’t go wrong with either of these funds.
The deciding factor depends on whether you think smaller cap companies will outperform mid and large-cap companies in the future. If so, go with VTSAX. If not, find an S&P 500 tracking index fund such as VFIAX.
Isn’t having only one or two index funds risky?
It can feel scary putting the majority of your assets into one or two ticker symbols.
It feels like you aren’t diversified at all. But the truth is, you’re much more diversified than an investor who chooses to put their eggs into 100 different individual stocks.
That sounds like a lot, but it’s less than your 500+ individual stocks all wrapped up neatly into one mutual fund or ETF.
It also sounds scary when you realize you’re paying a fund manager to do the managing.
What if they screw up and lose you money?
While that may very well be true for actively managed funds, index funds are passively managed. The fund manager closely tracks the index and reallocates the fund accordingly.
They aren’t gambling with your money. If you want to diversify, consider investing in other things instead, such as bonds.
Should You Buy the Mutual Fund or ETF of an Index Fund?
It all comes down to preference. Here are some of the factors you should consider.
For comparable index funds, the ETF generally comes at a slightly lower expense ratio than its mutual fund counterpart.
The reason is that mutual funds are always looking to acquire new investors to participate in the funds. To do this, they need to market the funds, and that costs money. The cost to market gets passed down to the shareholders.
On the other hand, ETFs don’t need any marketing. Just being on the exchanges alone gives them widespread and potentially global exposure to investors.
However, the slight edge in expense ratios often doesn’t matter much unless you’re investing multiple millions. For comparison, $1,000,000 invested in:
VTSAX (mutual fund): costs $400 in management fees per year
VTI (ETF): costs $300 in management fees per year
At this point, if you’re investing a million, does a $100 difference matter much to you?
Minimum To Invest
Depending on how much you have saved up, you may have to start off investing in ETFs.
VTSAX has a minimum of $3,000 to participate in the mutual fund.
VTI costs a bit over $200 for one share (at the time of this writing).
If you’ve got less than $3,000, you can either save up for VTSAX or jump-start your investing game and just buy some VTI.
Not all mutual funds have investing minimums. But many of the popular ones do, so keep that in mind.
One reason you may prefer ETFs is if you plan to do some active trading with them.
That’s right. You can actively trade a passively managed ETF.
If you feel strongly about buying at the dip and selling at a high, you should probably stick with ETFs, as this type of index fund will allow you to trade throughout the day.
Mutual funds can only be bought at end of the day, and the price at the end of the day is the price you get.
Also, if you want to sell at the current price, but it’s after-market hours, you won’t be able to.
You’ll be at the whim of the following day’s market sentiment, and that’s the price you’ll get. You won’t know whether it’s going to be higher, lower, or the same price.
Should My Index Funds Be Domestic or International?
It’s a hotly debated topic, but expert advice generally recommends that you have a mixture of U.S. stocks, international stocks, and bonds in your portfolio.
Allocation depends on your risk tolerance. By having international exposure, you’re theoretically diversifying your assets.
But are you really?
The world is highly globalized. Countries are intertwined economically speaking, especially with the U.S.
Supposedly, by having international stocks, you’re hedging your bets in case the U.S. market crashes.
But if it did crash, international stocks are likely to be affected as well. Perhaps not as much, perhaps more so.
On the flip side, U.S. stocks are also intimately tied to the global economy.
This provides international exposure within U.S. stocks without having to buy into international stocks.
The 4% Rule
Index funds are the investing vehicle of choice for those who FIRE (Financial Independence, Retire Early). The idea behind is that if you only take out 4% of your total investment each year, the money will be able to support you indefinitely due to the stock market returns.
To learn more, check out the 4% rule here.
Some investors prefer a simpler portfolio, one consisting of U.S. stocks and some bonds. Others prefer some international exposure, opting for a 3-fund portfolio.
Since index funds inherently contain numerous holdings within them, it’s hard to argue for anyone needing more than one to two index funds in their investment strategy.
They’re already highly diversified.
Either way, index funds have proven over time to be a great core holding for all types of investors, and no one should do without one. Or two.