Index Funds: 10 Tips

Curious about index funds and 10 tips to help you manage your investments? Savvy investors maximize their investments in index funds by understanding all there is to know about these funds. These 10 tips will help you protect your investment, maximize your returns and minimize your risk. Index funds can be an excellent tool in an investor’s toolbox to diversify a portfolio, match an index’s return with ease and to manage risk.

1. Understand the fee structure of the index fund. All index funds come with associated fees and costs. Understanding the fee structure of the fund is essential to compute expected returns and to compare different index funds which track the same index. Read the prospectus to get a rundown of all fees and costs charged by the fund.
2. Analyze past performance of the index fund. Does it match the index it is supposed to mimic? An index fund is only useful if its performance matches the index it is supposed to track. Analyze past returns of the index and the associated fund; look for a fund that meets or beats the index consistently.
3. Be familiar with the industry or commodity the index tracks. All investors should invest in companies or products they are familiar with. Understanding the underlying commodities or securities will eliminate surprises and help you to manage risk.
4. Who manages the fund? Does the fund manager have appropriate experience? What trading strategies do they use? While management of index funds is typically more passive than mutual funds with differing strategies, a competent manager is still essential to mitigate the risk of inappropriate decisions.
5. Does the fund pay dividends, reinvest dividends or only support capital gains? Investors must understand how they are going to get a return on their investment and what that return will be. Knowing when you get paid, and how you get paid, is a requirement for any investor.
6. How are you going to monetize your investment? If the index fund you buy into is not liquid, monetizing your investment could prove challenging. Be sure that you have a strategy to get out of your investment, especially if it will take time.
7. Are there competing index funds with a lower fee structure? Most of the big indices (S&P 500, Russell 2000, etc.) have many different index funds that track their results. Research to see which fund provides the most consistent returns with the lowest fee structure.
8. Make your own determination of future performance. It is wise to invest in an index fund only if you expect an adequate return on that investment. This requires you to determine what return is acceptable to you, research the index fund and determine if you believe the index fund’s expected performance will match your requirements.
9. Do not be afraid to bail—sell! If the fund is not performing up to your expectations, get out of your investment. Pick something else that will meet your expectations.
10. Ensure the index funds are part of a broader portfolio whose risk profile is appropriate for your situation. Index funds, like all other investments, are just part of your investment portfolio. Regularly review your entire investment portfolio to determine if the overall portfolio risk is appropriate for you and your situation. If it is not, make changes. Some of those changes may mean getting out of currently held index funds or adding additional index funds to the mix.

Resources:

Iowa State University