Christine Benz: Hi, I'm Christine Benz from Morningstar. Buying index mutual funds is an easy way to simply your investment life. You won't be able to beat the market but you will be able to come close to its return, and that's better than most active stock and bond pickers have managed to do over long periods of time. The real beauty of indexing though is that you can build a very streamlined portfolio that needs very little in the way of day-to-day oversight. For that reason, index funds can be a great choice for investors who don't have a lot of time to devote to their investments.
Unfortunately choosing the right index funds for you isn't all that simple. Index funds, both conventional mutual funds and exchange traded funds, have exploded in popularity over the past decade.
To help narrow down the field, I'd suggest you turn to Morningstar's Premium Fund Screener which is located on the tools cover page of Morningstar.com. The Premium Screener helps you narrow down the field of traditional mutual funds to those that are worthy of more research. Start by selecting the fund category that you would like to investigate.
Let's assume we are looking for a broad-based core stock index fund and most of these funds land in the large cap lend category. From there we will want to home in on all of the index funds that land in this category.Read Full Transcript
Costs are a key consideration for index funds because they are essentially commodity products where the expense ratio is the key differentiator. Most of the good plain vanilla index funds cost less than 0.25% per year. So I will look for index funds that charge that amount or less.
That narrows down the field but you can further cut it down by focusing on funds for which we have an analyst report. Finally we will focus our search on no-load funds that let you in the door with a reasonable initial contribution.
That screen takes the field down from hundreds of index funds to just seven that merit further research. From there you can read the analyst report to see whether our analysts think a fund is a good bet or not.
One other key consideration for indexers is whether you want a traditional mutual fund or an exchange traded fund. Once again, the answer to that question boils down to costs, and it also depends on how you plan to invest. Will you make a one-time investment or lots of smaller purchases in the future?
To help get your arms around the question of whether you are better off with an index fund or an ETF that tracks the same benchmark, turn to Morningstar's Cost Analyzer, which is also a premium tool. You will enter how much you plan to invest initially and how much you plan to invest in the fund each month thereafter. You will also enter how long you plan to hold the funds.
Because the Cost Analyzer is projecting which fund will be the better bet for you in the future, you will also have to enter an expected rate of return for the funds over the next decade. The Cost Analyzer has a preset rate of 10%, but I think that maybe a bit optimistic. I'd set it to 8%.
Then enter the ticker names for any funds you'd like to compare as well as whether you would pay any commissions to buy them. You will see that for investors who make regular monthly contributions, the traditional index fund is going to be the better bet in the ETF even though the expense ratio on the ETF is lower.
That's because exchange traded fund investors have to pay commissions when they buy additional shares each month. For investors who make one lump sum contribution and let it ride, the ETF is definitely a better choice in this case.
Indexing is a sensible strategy but it pays to do your homework. Morningstar's tools can help make quick work of selecting the right funds for you. And if you are not a premium subscriber, you can still use Morningstar's premium tools for two weeks by taking a free trial. Thanks for watching. I'm Christine Benz.