How to Select Low Cost Index Funds

Written by , June 20, 2012

How to Select Low Cost Index FundsThe ups and downs of the stock market are often too much for individual investors to want to deal with. It seems as if the performance of individual stocks often bears little relationship to how well the underlying business is doing, so in such an uncertain environment many investors have reduced their exposure to individual stocks.

But the risks of keeping your investment funds in cash, money market accounts or bonds should not be underestimated. With yields on many of these investment products barely above the rate of inflation rates, you’re actually losing money in real terms. One possible solution to this problem is investing in passively managed index funds. Because there’s no management expertise necessary, you’re likely to select an index fund on the basis of price.

Here is some investing advice on how to select low cost index funds.

  • Select Your Investment Focus. Before you can choose between index funds, you need to identify the particular index you want to track. The most common index funds track broad indices such as the NASDAQ or the S&P 500. But there are also index funds that focus on specific countries outside of the U.S., specific geographic regions or even specific industries. Once you select the index you’re interested in, you can begin to compare individual funds.
  • Identify All Relevant Costs and Fees. Regardless of the fund you choose, you’re likely to be faced with several different types of fees. Index funds won’t have management fees as high as active funds, but there will be a fee to cover the costs of making the underlying trades so that the fund’s holdings will always match the corresponding index. Each fund will also have an expense ratio to cover the administrative fees associated with operating the fund. Make sure to only compare funds that focus on the same index.
  • Avoid Sales and Transaction Fees. Because the performance of various funds tracking the same index should be virtually identical, you shouldn’t have to pay a sales load or other transaction fee just to buy a particular fund, hoping that that fund will outperform its peers. Unless you want to purchase a fund that tracks a highly specialized index, and there are no other funds that do so, there’s always likely to be another fund that does not charge those fees.
  • Minimum Investments. A sometimes overlooked aspect of selecting an index fund is the minimum required investment. If the minimum investment of a particular fund is high, and you’ll have to liquidate some of your other investments in order to purchase that fund, then the costs of doing so should also be factored into your decision.
  • Investing in index funds can be a great way to get exposure to the equity markets without having to face the risk of selecting individual stocks, or may significant fees for an actively managed mutual fund. By comparing the fees charged by similar funds you’ll ensure that you’re making the best decision with your investment dollars.

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