The importance of a varied investment portfolio is well-known. Not only does it help maximize profits, but it also keeps one’s assets safer. In addition to equities, hedge funds, and stocks, many people today also invest in index funds. These are a group of stocks that mimic the appearance of an existing market index and offer simple returns. Read on to learn more about index funds, how they work, and how to identify the best ones.

What are Index funds?
Index funds are made up of the same investments as the index tracked. Since their performance is similar to that of the index, they generally require no hands-on management. One distinct factor about these funds is that they do not try to exceed the market. Instead, they replicate the market by buying stocks of all the listed companies. This way, the returns match the performance of the index as a whole.

They are considered a passive investment strategy to balance one’s portfolio, making them great for people who do not want to spend too much time or energy monitoring the market daily.

Identifying the best index fund to invest in
Picking an index fund can be a challenge. Here are some things to keep in mind while investing:

Pick a fund with the lowest expense ratio
Index funds often have an associated annual fee called an expense ratio. This small fee covers the cost of buying and selling the investments and managing them. In most cases, however, this fee is not listed transparently. It is deducted as a percentage of one’s return on investments.

After shortlisting funds that could benefit one’s portfolio, experts recommend looking for one with the lowest expense ratio. This can help one maximize their investment profits.

Don’t worry about the ETF vs Index Fund difference
Many people get confused about the difference between an ETF and an Index Fund when starting on their investment journey. In simple words, the major difference between an Exchange-traded fund (ETF) and an index fund is how often their share prices change.

Let’s break this down further. With an index fund, buyers can place an order any time. However, the price of this purchase is determined by the value of the securities at the end of the current trading day. On the other hand, an ETF is processed like a stock, and its price continues to change throughout the day. Choosing the right one here depends on the investor’s experience in the stock market, investment amount, financial goals, and ability to take risks.

Understand how it works in the portfolio
The choice of an index fund also depends on the role it is expected to play in one’s portfolio. Once an index has been selected, it is time to find a fund that tracks it. With popular funds, there can be several options available. Check the following details:

• How closely does it track the index?
• Which one has the lowest costs?
• Are there any limitations that may restrict the investment?
• Does the fund provider have other funds that may also provide an interesting opportunity?

Look for a fund with the lowest tracking error
When selecting an index fund, it is also important to pay attention to factors such as tracking errors. This information can be found in the fund’s fact sheet and can be crucial in identifying a fund with consistent returns.

Building a portfolio with index funds

• Choose one target date fund
  For a retirement portfolio, it may be a good idea to invest in a fund with a target date (any fund with a year in the title). This date should be close to one’s 65th birthday. This completely takes out any individual involvement in the fund. The target date fund invests in a mix of stocks and bonds – typically using low-cost index funds or ETFs.
• Three-fund approach
  Alternatively, one can also take the three-fund approach. This includes a total stock market index fund, an international stock index fund, and a high-grade U.S. bond index fund so that investors can customize the equity-to-bond ratio as per their preferences.

What makes index funds a top choice?
There are several reasons why index funds have become a top choice among investors. These include:

• Minimal research
  Unlike individual stock options, these funds require little research, making them a quick and easy investment option.
• Managed risk
  Index funds already present a diverse range of companies. This spreads one’s investment, reducing the risk of major losses.
• Tons of choices
  Just like stocks, there are a lot of options to choose from when it comes to i ndex funds. Investors can buy broad index funds, or look for those catering to a particular category or industry.
• Low associated fees
  As compared to actively managed funds, index funds also have lower associated fees. This is because the manager only has to work on them passively instead of monitoring them constantly.
• Tax efficiency
  Since there is very little buying and selling involved, these funds are also quite tax-efficient.
• Help build a portfolio
  Index funds allow investors to put in money every month without worrying about regular ups and downs. This helps them passively build a strong investment portfolio.