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A How To On Index Funds

1. Choose a benchmark index

Garza & Harris LLC say that while the Standard & Poor’s 500 index is one of the best-known indexes, it isn’t the only index around. There are indexes — and corresponding index funds — composed of stocks or other assets chosen based on:

  • Company size and capitalization
  • Geography
  • Business sector or industry
  • Asset type
  • Market opportunities

There are an array of choices, but you only need to invest in only one.

2. Compare fees for fund management

Low costs are the biggest selling points of index funds. They’re cheap to run because they’re automated to follow the shifts in value in an index. But, unfortunately, even though they’re not actively managed by a team of well-paid analysts, they still carry administrative costs.

Those costs — the main one is the expense ratio — are subtracted from each fund shareholder’s returns as a percentage of their overall investment. Find the expense ratio in the mutual fund’s investor prospectus or when you call up a quote of a mutual fund on a financial site.

3. Think about potential tax issues

Garza & Harris say you need to consider another cost – the tax-cost ratio, which is how much owning the fund may trigger in annual taxes. This is important if you’re investing in a taxable account as opposed to an IRA or a 401(k).

Transactions within a mutual fund — when stocks are bought or sold or when companies distribute dividends — can generate capital gains taxes. Like the expense ratio, these taxes can take a bite out of investment returns. This is typically an issue with actively managed funds where investors sacrifice 0.75% in average annual returns versus just 0.30% in returns when invested in an index fund.

4. Make sure returns match the index

The index fund’s returns are on the mutual fund quote page. It shows the index fund’s returns during several time periods, compared with the performance of the underlying benchmark index.

Don’t panic if the returns aren’t identical. Remember, those investment costs, even if minimal, affect results, as do taxes. However, red flags should wave if the fund’s performance lags the index by much more than the expense ratio.

5. Check the fund’s investment minimum

Charges keep rearing their ugly heads. This time it’s the cover charge, or the investment minimum required to get your foot in the door. It can actually run as high as a few thousand dollars.

A workaround however is to invest in an exchange-traded fund (ETF) that tracks an index. ETFs are like mini mutual funds that trade like stocks throughout the day. Instead of having to buy the main-course mutual fund, you purchase a slice of the fund.

6. Decide how to buy

You can purchase an index fund directly from a mutual fund company or through a discount brokerage account. The same is true for ETFs. When you’re choosing where to buy an index fund, ask Garza & Harris about:

  • Fund selection.
  • Convenience.
  • Account minimum.
  • Commission-free options.
  • Trading costs

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