How to Master Index Investing

Why struggle to find a needle in a haystack when you can buy the haystack? That was Vanguard founder Jack Bogle's argument for indexing nearly half a century ago when he launched the first index fund for individual investors. The investment approach was easy to execute and offered instant diversification, all for a low fee. And as it turns out, returns have been tough to beat.

Index mutual funds and exchange-traded funds (ETFs) have done better, on average, than most actively managed funds for years. The Vanguard 500 Index Fund (VOO), which mirrors the S&P 500 Index, has outpaced 76% of all active large-company U.S. stock funds over the past 15 years. (Returns and other data are through August 31; funds we recommend are in bold.) 

Today, index funds account for nearly 60% of assets in diversified U.S. stock mutual funds and exchange-traded funds (through July), up from one-third of assets a decade ago. And now, "there's an index-based strategy for whatever an investor wants to get exposure to," says Todd Rosenbluth, head of research at financial data firm VettaFi. 

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We're still fans of active funds, of course, albeit selectively. But on average, active managers have found it tough to beat the S&P 500, which has made indexing a popular strategy. "That's why we prefer index investing over active," says Alvin Carlos, an adviser in Washington, D.C. "We don't want to invest in a losing strategy." 

In recent years, however, this simple investing strategy has become more complicated. And education has failed to keep up. 

"Fifteen years ago, indexing was about just measuring the broad market," says Aniket Ullal, head of exchange-traded fund data and analytics for CFRA Research. Then came designer index funds, or funds that track customized benchmarks with the goal of beating the traditional bogeys. Now, complex options-based strategies are hitting the market. Some index funds "can be tricky even for the most-sophisticated investors to understand," says Ullal. 

To help you master the art of indexing, use our guide, below, to explore different parts of the indexing world for both stocks and bonds. The choices range from traditional broad-market funds to funds that zero in on certain investing styles and strategies or particular market themes to complex offerings that bear little resemblance to Bogle's big idea. 

Traditional stock index funds

Funds in this category have two defining traits: They track a broad, well-known index, such as the S&P 500, the Nasdaq-100 or the MSCI EAFE, and they weight portfolio holdings by stock market value. The bigger a company's market capitalization, the bigger its position in the fund. 

What you see in the index is what you get in the fund, which is why traditional index funds are good choices for your core portfolio. "That's the nice thing about indexing," says Chris Huemmer, a senior client portfolio manager at FlexShares ETFs. "It's all rules-based, so there's no strategy drift." 

Even so, take the time to understand exactly what kind of index fund you're buying, the rules that govern its underlying holdings and how it has behaved in past markets. "Two products may have similar names and objectives but own different stocks," says Rachel Aguirre, head of U.S. iShares products. 

Consider, for example, three small-company index funds: the iShares Russell 2000 ETF (IWM), the SPDR Portfolio S&P 600 Small Cap ETF (SPSM) and the Vanguard Small Cap Index (VB). Each fund tracks a different index, so performance varies. Companies in the Vanguard portfolio, for instance, are twice as big by market value, on average, than the companies in the other two funds. That has helped the Vanguard fund perform better in recent months because bigger companies outperformed small ones. Similarly, companies in the SPDR fund are more profitable overall compared with holdings in the other two funds because its index, the S&P SmallCap 600, limits constituents to firms with profits. That helped the SPDR ETF outperform the other two small-company funds in 2021. 

Another tip: Stick with the same index family if you're buying individual funds to get large-, small- and midsize-company exposure. Pair an S&P 500 index fund, for instance, with an S&P SmallCap 600 index fund to avoid any overlap in stock holdings. We did that in the Kiplinger ETF 20, our favorite exchange-traded funds, matching the iShares Core S&P 500 ETF (IVV, expense ratio 0.03%) with the iShares Core S&P Mid-Cap ETF (IJH, 0.05%) and the iShares Core S&P Small-Cap ETF (IJR, 0.06%). 

Investors who prefer mutual funds should consider the Fidelity 500 Index (FXAIX, 0.02%) or the Schwab S&P 500 Index (SWPPX, 0.02%) for large-cap exposure. Otherwise, invest in a total market fund, which owns nearly every publicly traded stock. The Vanguard Total Stock Market trades as a mutual fund (VTSAX, 0.04%) and an ETF (VTI, 0.03%). 

Strategic index funds: factor funds

These funds still aim to beat a broad benchmark, but they come with a twist. Funds that aren't weighted by market cap fall into this category, for instance. The main types of strategic funds are focused on factors (defined as stock or company traits that have been proven to drive returns), company fundamentals or a thematic trend. 

We'll start with factor funds. There are six main factors: value (inexpensive stocks), size (small-cap stocks, say), momentum (stocks with upward-trending prices), volatility (stocks with low price fluctuations), quality (financially healthy firms) and yield (stocks that pay dividends). Invest in these funds alongside your core holdings to enhance returns or reduce risk. 

Factors can take years to pay off. That's why these funds are best considered long-term, buy-and-hold investments, says Nick Kalivas, head of factor and core equity product strategy for Invesco ETFs. Size and value, for instance, win over multiple decades. "Ten years is too short," he says. Quality, value and momentum, on the other hand, can reward in five-plus years. 

But factor investing has some quirks. The strategies don't all work – as in outperform the indexes – at the same time. When the economy is contracting, low-volatility, value and quality factors outperform, and momentum and size tend to lag. During an economic recovery, size, value and quality fare best; momentum and volatility lag. 

You can find funds that focus on a single factor – Fidelity and BlackRock's iShares each have several, to name just two shops. And some funds group factors because they pair well. Momentum and low volatility, for instance, work well together. And quality and value are good pairs, too. But the jury is out on whether you should own all the factors at once – Invesco's Kalivas says yes because it adds diversification benefits; FlexShares' Huemmer says no because it could water down returns. 

That's why we favor a flexible approach. The Invesco Russell 1000 Dynamic Multifactor ETF (OMFL, 0.29%) stresses different factors depending on whether the economy is expanding, slowing down, contracting or recovering. Over the past one, three, five and 10 years, the fund has outpaced the S&P 500 (and the Russell 1000) and boasts a better risk-adjusted return, but it has been more volatile, too. 

Equal-weight funds are factor funds because they emphasize size, in a way – every company, small or large, gets an equal share of assets. They're a way to avoid overweighting the most popular stocks of the day. Just remember, over shorter periods, performance can be choppy. For instance, the Russell 1000 Index has notched a 15.4% gain over the past 12 months, but the Invesco Russell 1000 Equal Weight ETF (EQAL, 0.20%) is up just 3.8%. And although the Invesco S&P 500 Equal Weight ETF (RSP, 0.20%) beat the S&P 500 Index over the past three and 20 years, it lagged over five, 10 and 15 years. 

With fundamentals funds, business metrics, such as revenue and free cash flow (a company's cash from operations after capital expenditures), matter most. 

The Invesco S&P 500 Revenue ETF (RWL, 0.39%), for instance, ranks stocks by trailing 12-month revenue and rebalances every quarter. Walmart and Amazon.com are top holdings. The fund bested the S&P 500 over the past three-year period, but it was a step behind the index over the past five and 10 years. 

The WisdomTree US Earnings 500 ETF (EPS, 0.08%) holds profitable large stocks ranked by earnings. The fund also beat the S&P 500 over three years but lagged over the past five and 10 years. 

Companies that throw off cash are the focus at the Pacer U.S. Cash Cows 100 ETF (COWZ, 0.49%). Stocks are ranked by trailing 12-month free cash flow. Over the past five years, the fund beat the S&P 500. 

Finally, the Schwab Fundamental US Large Company Index (ETF symbol FNDX; mutual fund symbol SFLNX; expense ratios 0.25%) tracks an index that ranks stocks using a combination of sales, cash flow, and dividends plus buybacks. The fund lagged the Russell 1000 over the past one and five years, but it beat the majority of large value funds in every calendar year over the past decade except 2022. Fit funds like these into your portfolio as complements to your core holdings to boost returns.

Strategic index funds: thematic funds

Funds that fall into the thematic subcategory let you follow your passion. These days, whatever your interest, you can find an ETF that captures the trend. There's one for working at home – the Direxion Work From Home (WFH) – and one for pet care – the ProShares Pet Care ETF (PAWZ) – and there are several clean-energy offerings such as the iShares Global Clean Energy ETF (ICLN) and the Invesco Solar ETF (TAN). 

Several are technology related, including the Global X Robotics & Artificial Intelligence (BOTZ) and the Global X Autonomous and Electric Vehicles ETF (DRIV). Some market watchers, including Invesco's Kalivas, count funds that invest according to environmental, social and corporate governance principles in the thematic category. 

In most cases, thematic funds are best reserved for money you can afford to set aside for the long haul. "These funds tap growth drivers that will play out over a long time period," says iShares's Aguirre. 

You should buckle up, too, because they can be volatile. The Ark Innovation ETF (ARKK), for instance, soared 153% in 2020, only to lose 23% in 2021 and another 67% in 2022, before it rebounded sharply in 2023. 

Quasi-index funds

The lines between index funds and active funds are blurring. Some consider the strategies we describe below as actively managed. But their outcomes are tied to an index, so we consider them quasi-index funds. 

Buffered ETFs. Investors who want to stay invested in stocks but can't afford – or stomach – big downdrafts are flocking to "defined outcome" funds, also called buffered ETFs, which invest in options tied to a broad index. The ETFs offer some protection from stock market losses over a 12-month period in exchange for a cap on potential gains. How much you give up in returns (the cap) depends in part on the amount of downside protection (the buffer) the fund offers. The bigger the buffer, the lower the cap. 

Take the Innovator S&P 500 Buffer ETF July fund (PJUL). Investors who bought shares in this ETF at the start of July had a 9% buffer against losses and a cap on returns of 19.24%. If the S&P 500 ETF drops by up to 9% over the 12-month period ending in June 2024, shareholders lose nothing. If the S&P 500 declines by 15%, shareholders will suffer only a 6% loss. 

Most buffered ETFs are linked to the S&P 500 Index, but some are tied to the Nasdaq-100, the Russell 2000 or the MSCI EAFE, among others. At the end of the one-year period, the fund resets by buying new options, which will define the buffer and cap parameters over the next 12-month period. That's why these funds typically have a month tied to their name. But you can buy and hold these funds if you like; there's no termination date. 

Look for buffered ETFs from Innovator, First Trust, AllianzIM, TrueShares and Pacer. Be sure to buy shares in a defined-outcome ETF within a week of the start of its 12-month stretch in order to benefit from the fund's full downside buffer. In late October or early November, for example, buy a November-dated ETF. And stay invested for at least the full year. For investors who don't buy at the start of the period, the buffer and cap shift a bit depending on the fund's net asset value each day. 

Direct indexing. This strategy once was reserved for high-net-worth individuals, largely to goose after-tax returns. It is now accessible to regular investors, thanks to free and fractional-share stock trading, as well as lower minimums to invest. 

In direct indexing, also called "personalized indexing," you directly own the individual stocks of an index (or a representative set; more on that later). Plus, you can tweak your holdings to suit your needs or values. If you work for Apple (AAPL), say, and don't want or need added exposure to the stock, you can exclude it from your personalized index. 

Tax-loss harvesting, which aims to reduce your capital gains tax, is key to direct indexing. Say you're tracking the S&P 500, and Exxon Mobil (XOM) shares trade at a loss in your portfolio. With tax-loss harvesting, you would sell the shares – locking in losses to offset gains in other investments – and replace Exxon with a stake in a different but similar index stock (Chevron (CVX), say) to maintain proper allocation in your portfolio. 

"The end result is less of your money goes to taxes, and more stays invested and working for you," says Eric Walters, an adviser in Greenwood Village, Colorado. You wouldn't own every stock in the benchmark index when you use direct indexing – otherwise you'd limit your options to reinvest in a similar security, according to IRS rules. 

Tax-loss harvesting can add up to 0.5 to 1.5 percentage points a year in returns by reducing taxes, adds Walters. Of course, the more money you have in the portfolio, the more effective the strategy, and it only works in a taxable account. 

Not everyone is a believer. "You can gain tax benefits, but you risk underperforming, too," says Carlos, the Washington, D.C., adviser. Some advisers say you need to invest at least $2 million to make direct indexing worthwhile. Others say only the wealthiest investors – those in the highest tax bracket or those who know they will leave the account to their heirs – should consider it. Fees are between 0.2% and 0.4% of assets per year. 

If you're interested, consider going with an adviser who offers the service. Not all do. "It's an extra expense and takes time, so the client has to really care about it," says Eric Figueroa, a certified financial planner in Folsom, California. Minimums range between $25,000 and $250,000 or more. Figueroa prefers that clients have at least $50,000. 

Some brokerage firms offer personalized indexing services, too. Fidelity's Managed FidFolios have a minimum of $5,000 and charge a 0.4% fee. At Schwab, the minimum is $100,000, and fees are 0.40% for balances below $2 million. You must work with a Schwab financial consultant. 

Bond indexing

Indexing with bonds hasn't received as much attention as stock indexing. That may be because historically, most actively managed bond funds have outpaced their benchmark, at least over long hauls. 

But that's changing. In 2022, the worst year for fixed income in decades, bond index funds fared better than their active counterparts. Lately, investors have been rushing headlong into bond funds, particularly passive ones, as higher yields have made fixed-income investing more attractive. 

That said, bond indexing comes with some caveats. Rather than hold every security in the bogey they track the way stock index funds do, bond index funds hold a sampling. Sometimes, that can drive up tracking error (the divergence between the return of the fund and the return of the index it tracks). Also, unlike an individual bond that you buy and hold to maturity, bond fund yields can shift as the mix of securities in the portfolio changes and as interest rates fluctuate (because bond prices and yields move in opposite directions). 

Traditional offerings. Traditional bond index funds are weighted by market value of debt. The U.S. bond market yardstick is the Bloomberg U.S. Aggregate Bond Index, better known as the Agg. It was "never meant to be a comprehensive market benchmark," says Jason Bloom, Invesco's head of fixed-income ETF strategy. It's not diversified, for a start. Nearly 70% of the index is made up of government and government-agency bonds. And it excludes some key sectors, including high-yield debt. 

That said, an Agg-based index fund works as a core holding. Our favorites are the Fidelity U.S. Bond Index Fund (FXNAX, expense ratio 0.03%), which yields 4.5%, and the iShares Core U.S. Aggregate Bond ETF (AGG, 0.03%), which yields 4.3%. 

Fill in the gaps of the Agg by peppering your portfolio with small doses of bank loans, high-yield corporate credit and even preferred securities (bond investments with stock-like features) to boost your return over time. For high yield, we favor the SPDR Portfolio High Yield Bond ETF (SPHY, 0.05%), which yields 8.5%. Our favorite floating rate fund is the Invesco Senior Loan ETF (BKLN, 0.65%). It yields 8.6%. For preferred stock ETFs, we like the iShares Preferred & Income Securities ETF (PFF, 0.46%), which yields 6.6%. 

Factor funds for bonds. It's a new-ish category, so there aren't many factor-based bond funds. But we found a few we like. 

The FlexShares High Yield Value-Scored Bond Index Fund (HYGV, 0.37%) and the iShares High Yield Bond Factor ETF (HYDB, 0.35%) emphasize securities that score well on quality and value measures, though their approaches are different. Over the past five years, both funds outpaced the typical high-yield bond fund, with better than 3.2% annualized returns. The FlexShares fund yields 9.7%; the iShares fund, 8.6%. 

Securities in the ultra-short-term bond fund Fidelity Low Duration Bond Factor ETF (FLDR, 0.15%) are weighted by interest rate sensitivity. Over the past 12 months, the fund's 4.9% return outpaced 77% of other ultra-short bond funds. It yields 5.7%. 

The Invesco Fundamental Investment Grade Corporate Bond ETF (PFIG, 0.22%) relies on book value (assets minus liabilities), sales, dividends and cash flow to weight securities. Over the past five years, the fund beat 60% of corporate bond funds. It yields 5.2%.

Laddering for income. To smooth out current income, some investors build a bond ladder, which involves buying bonds that mature at in-creasing intervals, say, every year over the next 10 years. As each bond matures, you reinvest the principal in the long end of the ladder. 

Now, thanks to Invesco and iShares, you can build a bond ladder with index ETFs. These target-maturity funds, dubbed Invesco BulletShares and iShares iBonds, offer instant diversification and more liquidity than you'd get by buying individual bonds. 

You can invest in a ladder of investment-grade corporate debt or high-yield IOUs with Invesco BulletShares funds. Maturity dates stretch between 2023 and 2032. Expense ratios for the investment-grade corporate funds are 0.10%; the high-yield BulletShares funds cost 0.42% a year. The iShares iBonds suite has a Treasury track or an investment-grade corporate debt track, with maturity dates that fall between 2023 and 2033. Expense ratios for the Treasury ETFs are 0.07%; the corporate iBonds funds charge 0.10%.  

Should you choose an ETF or mutual fund?

Should you go with an exchange-traded or mutual index fund? It's largely a matter of personal preference. Mutual funds and ETFs are both easy to trade and offer diversified exposure to a swath of the market in one step. They both pool assets from shareholders and invest in diversified baskets of stocks or bonds or other assets. And both ETFs and mutual funds charge an annual expense ratio. But they differ in key ways, too.

Trading. Mutual fund trades are executed once a day, after the market closes. In some cases, you may have to pay a transaction fee to purchase shares in a mutual fund. ETF shares trade during the trading day, just like stocks do, for no fee at most brokers. 

Minimums. Some mutual funds have no minimums. But the initial investment for a Vanguard index fund is $3,000. No ETF is that pricey – the minimum is the price of one share. 

Expense ratios. ETFs have lower expense ratios than mutual funds, generally speaking. Part of the reason is that most ETFs are index funds, which are less expensive to run than actively managed funds. But ETFs also don't incur certain expenses that mutual funds do, such as fees paid to list the mutual fund on a brokerage firm's no-transaction-fee platform, for instance. 

Capital gains distributions. ETFs are structured to be more tax-efficient than mutual funds. ETFs don't actually buy and sell the underlying securities in their portfolios; third parties called authorized participants do it for them. Because an ETF isn't making actual cash transactions, it is less likely to make capital gains distributions to share­holders. (You still owe capital gains taxes when you sell shares.) 

That's not the case with a mutual fund. If a mutual fund sells a security in its portfolio and pockets a profit, it is required to pass on those gains to shareholders at least once a year in the form of a capital gains distribution. This doesn't apply if you hold the fund in an IRA or a 401(k). These investments are shielded from tax until you withdraw from the account. But if you hold the fund shares in a taxable account, you're vulnerable to an unexpected tax bill.

Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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