Index Funds are mutual funds that track the benchmark indexes passively. An exposure to a holding can be in the hundreds or thousands and there is a science involved in getting it right. An index is a sample of securities that characterize a particular market segment. An index fund is created when the management team of a fund decides how many shares of a holding they need and purchase them. The point is to match the index in percentage weighting. Indexes rank the holding so that larger percentage weightings are given larger components. These indexes are called capitalization-weighted indexes. The best index funds generally reflect the capitalization-weighted indexes by making stocks with the biggest capitalization the biggest holding in the index fund in terms of percentage by buying the shares of these holdings. Examples of top holdings are Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG), and Facebook (FB). Market capitalization measures these companies as having the largest stocks.
There are several reasons why investors choose index funds. The first is the potential for passive management. All the manager of an index fund has to do is buy and hold securities with the purpose of matching the performance of the index to the index represented by the securities. The idea is not to beat it but match it. The next reason is the low expenses involved. Due to passive management where the index fund manager is not involved in active trading or securities research, the costs involved are much lower. Lower expenses are, of course, a big plus because it means higher returns. The third reason is tax efficiency. The idea of keeping expenses low is to minimize taxes. Because of their passive functioning, index funds have lower capital gains distributions which translate to less taxes. Another reason is broad diversification because index funds invest in a wide variety of holdings, sometimes thousands of them. Index funds which have invested in more holdings are at a lesser market risk than those with less holdings. Index funds also provide more exposure to securities.
The best index funds are ones that have lower expenses, more diversified portfolios, and which generally last a lifetime.
The S&P 500 index is the best index fund. It represents 500 of the largest companies in the United States. Some of the best S&P 500 index funds include Vanguard 500 Index (VFINX), one of the first mutual funds to be made available to the public. It was found that after expenses, managers of funds could not beat market averages. However, by buying a low-cost mutual fund which made up a basket of stocks, one could get higher returns. Vanguard 500 Index has a minimum investment of $3,000. Its expense ratio is just 0.16%.
Another excellent index fund is Fidelity Spartan 500 Index (FUSEX) whose size, experience and competitive spirit make them only second to Vanguard. In terms of expenses and performance, the two are pretty much the same. Thanks to the competition between the two, the investor gets higher-quality funds. FUSEX has a lower expense ratio of 0.10% and a lower minimum initial investment of $2,500. Schwab S&P 500 Index (SWPPX) is another good index fund which has made a choice to provide investors with discount brokerage services. Their expenses are low enough to compete with VFINX and FUSEX. Their expense ratio is 0.09% and minimum initial investment is a mere $100.
According to Warren Buffet, one of the most successful stockbrokers in the world, the best index funds make for the most reliable retirement plan. His advice is to steadily purchase an S&P index fund that is low cost because it makes the most sense at any given time. He suggests that one should keep buying it consistently despite market fluctuations. He predicts that the world of investment in America will do very well and one of the proofs of this is that the Dow Jones Industrial Average rose from 66 to 11,497 in hundred years which was at the end of 1999. And since then, it has doubled.
Currently, it is somewhere in the range of 22,000. Buffet says that an index fund is the best bet to avoid purchasing individual stocks which are riskier. It is not about choosing the best company, it is about choosing all the best companies on the S&P 500 Index and buying steadily from them at a low cost. The point of low-cost index funds is fee saving. Buffet has taken shots at costly funds more than once. He firmly believes in low-cost index funds if one wants to make noticeable returns. One can keep more of their retirement savings by choosing low-cost index funds. Of course, luck plays a significant role even when you choose S&P 500 Index funds over multiple mutual funds with different asset strategies which always come with big fees. You can almost never pick a stock and hope to have an edge.