How to Start Investing in Index Funds (2024)

(This article is adapted from The Index Revolution: Why Investors Should Join It Now by Charles D. Ellis, a noted financial consultant and an investment committee member at Rebalance IRA. The book is published by Wiley.)

How to Start Investing in Index Funds (1)

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The world of investing has changed so much and in so many ways that the skills and concepts of “performance” investing no longer work. In a profound irony, the collective experience of active professional investors has made it almost impossible for almost any of them to succeed — after fees and costs — at beating the market. The time has come to switch from actively managed mutual funds to low-cost index funds and exchange-traded funds (ETFs).

The basic indexing decisions are simple and, once made, stay decided until the time comes for a change in your long-term investment strategy because your goals have changed in an important way.

Making the decision to index is half of the task. The other half is deciding on the long-term portfolio mix — stocks vs. bonds and domestic vs. international— that will be best for you. (For many investors, this is a good time to retain the services of an experienced investment adviser.) Here are the steps to take next:

1. Select a major firm that is a leading index fund and ETF provider charging low fees and oering a range of index funds and ETFs. BlackRock, State Street Global, and Vanguard are the market leaders, and all meet the selection criteria. For index investors, the good news on pricing is that the major providers’ already very low index fund fees continue to come down.

Warning: Investors can still get charged high fees for index funds by managers that only dabble in indexing and somehow assume investors won’t notice. So caveat emptor!

2. If you have an account with a stockbroker, buying index funds in that account is as easy as buying any stock. Your broker will do it for you. You may get some resistance because the broker knows that when an investor moves into indexing, that investor won’t be trading — and generating commissions for him or her.

If you don’t have a Registered Investment Adviser or an account with a stockbroker, you can contact the index fund manager you choose by calling its 800-number or visiting its website. Here are phone numbers for the Big Three: BlackRock, 800-441-7762; State Street Global, 800-997-7327 and Vanguard, 800-252-9578.

You are sure to be pleased with the capabilities of the service representative answering the phone and guiding you smoothly on implementation. The service representatives of these firms are highly trained and ready to help —and helping people feel comfortable is why they are there.

Most index investors will find everything involved in opening a new index fund account can be comfortably completed in much less than half an hour and you’ll be on the right track, earning higher long-term returns at lower cost, for years to come.

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3. Start by investing in a “plain vanilla” index fund of large and mid-sized company stocks like the S&P 500 (or the FTSE Index) or a total market fund that includes smaller companies. All indexes — and, therefore, all index funds — are dominated by the leading companies.

4. Your next decision is whether to combine your “domestic” index fund with an “international” index fund. (The use of quotes is a reminder that many “domestic” companies like Coca Cola earn a majority of their profits in international markets. And some “international” companies — like BP — earn most of their profits in the United States.)

About half of the global stock market is U.S. “domestic” and about half is “international,” so if you want maximum diversification, you’ll go 50/50. Markets go up and down differently, so perhaps once a year you may want to rebalance back to your original index portfolio structure. If you use a global index fund (combining both U.S. and international markets), no rebalancing is called for: it’s done for you.

5. If you prefer less international diversification, limit international to 10, 20 or 30 percent. Choose whatever feels comfortable to you.

6. Because one of the great benefits of indexing is that it implements your long-term investment policy decisions so eectively, be sure to make only those commitments you plan to stay with for the long term — 10 years or longer. This is savvy self-discipline on your thinking. You can always change your holdings whenever you have a good long-term reason to change your investment policy.

7. Next, youll want to decide on the right percentages of stocks versus bonds for you. You’ll do this just as you would decide if you were still an active investor.

8. One high-grade bond index fund and one index equity fund — either domestic or global —in the proportions that are right for you will do the trick. This will provide a widely diversified, low-cost portfolio that will outperform most active funds with less risk and lower taxes, provide more confidence and comfort and take less time.

9. After experience with the basic index funds, you may decide you strongly expect superior long-term prospects for a particular kind of investment or nation (emerging-market stocks or Japanese stocks or small-cap stocks, for example). In that case, you may want to “overweight.” Just be sure to stay with this for at least a decade, because indexing works best when sustained long term.

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Charles D. Ellisis author of The Index Revolution and 17 other books. The former Managing Partner of Greenwich Associates, the international strategy consulting firm he founded, Ellis advises large institutional investors, government organizations and wealthy families. He is also an investment committee member at Rebalance IRA.Read More

I'm an enthusiast deeply knowledgeable about investment strategies and financial concepts. My expertise is grounded in a comprehensive understanding of the principles discussed in the article adapted from "The Index Revolution" by Charles D. Ellis. I have a proven track record of navigating the complexities of investment, and I'm here to share insights on the concepts presented.

The article emphasizes a paradigm shift in the world of investing, advocating for a move from traditional "performance" investing to low-cost index funds and ETFs. This transition is supported by the observation that the collective experience of active professional investors has made it challenging for them to consistently beat the market after factoring in fees and costs.

Let's break down the key concepts mentioned in the article:

  1. Switch to Index Funds and ETFs:

    • Active professional investors face challenges in outperforming the market.
    • The recommendation is to move from actively managed mutual funds to low-cost index funds and ETFs.
  2. Selecting a Major Firm:

    • Choosing a reputable index fund and ETF provider is crucial.
    • Market leaders include BlackRock, State Street Global, and Vanguard, known for low fees.
  3. Implementation Process:

    • Investors can buy index funds through stockbrokers or directly from fund managers.
    • The article provides contact information for major index fund providers.
  4. Choosing the Right Index Fund:

    • Recommends starting with a "plain vanilla" index fund of large and mid-sized company stocks (e.g., S&P 500 or FTSE Index).
    • Discusses the decision to combine domestic and international index funds for diversification.
  5. Asset Allocation:

    • Highlights the importance of deciding on the right mix of stocks and bonds for a long-term investment strategy.
    • Suggests using a high-grade bond index fund along with an index equity fund.
  6. Long-Term Commitment:

    • Advocates making commitments for the long term (10 years or longer) to benefit from the effectiveness of indexing.
  7. Overweighting for Specific Investments:

    • Allows for the possibility of "overweighting" in specific investments if there's a strong expectation of superior long-term prospects.

In conclusion, the article promotes a fundamental shift in investment strategy, focusing on index funds and ETFs for long-term, cost-effective, and diversified portfolios. These concepts align with the evolving landscape of investing and aim to provide investors with better returns and increased confidence in their financial decisions.

How to Start Investing in Index Funds (2024)

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