How to evaluate index funds

Investors can use index funds to build wealth over time. An index fund is a type of investments or mutual fund that tracks the returns of a broader market index, such as the S&P 500, Russell 2000 Index, NASDAQ Composite Index, etc. Compared to stocks, index funds offer investors more diversification and less volatility. Here are just a few basic things to take into consideration when selecting index funds for your portfolio.

There are many factors to consider when selecting index funds to invest in. Without further delay, here are 6 of the many parameters to take into account.

1. Index fund's performance

An index fund's performance can give you a good idea of a its financial health. The index fund should mirror the returns of the index it is tracking. We typically look at a fund's performance over the last 1 year, 3 years, 5 years and 10 years. A fund with a consistent, acceptable or solid performance is one we would feel comfortable investing in. Also, we look at a fund's performance for the current year (YTD performance).

2. Expense ratio

The expense ratio is another important factor to consider when selecting an index fund. In very basic terms, the expense ratio tells you how much the fund charges annually to operate it, among other expenses. It is usually expressed as a percentage. Since they are usually passively managed, compared to active mutual funds, index funds normally have low expense ratios. For example, an expense ratio of 0.015% means that you pay $1.50 for every $10,000 you have invested in that fund. If you have $50,000 invested in that fund, you can expect to pay about $7.50. As you can see, it is prudent to select a fund with low expense ratios.

3. Minimum investment amount

Some funds require a minimum investment amount (e.g. $2500, $3000). This amount varies and depends on the broker, fund manager, investment strategy, among others. Other index funds have no minimum investment. We recommend an index fund with no minimum investment for any new investor, as you can start investing with as little as $1!

4. Overall rating and returns

You can evaluate a fund by looking at its overall returns and ratings. Funds are rated on a star scale, ranging from 1 to 5 stars. Returns are classified from low to high.

5. Net Asset Value (NAV)

The NAV or net asset value of an index fund is the dollar value of one index fund's share, excluding other fees. If the NAV of index fund Z is $10.45, it means you need $10.45 to purchase one share of index fund Z.

6. Index fund's top 10 holdings

An index fund is composed of a basket of individual stocks of different companies. Index funds mirror the returns of an index. They can include all the stocks or securities of that particular index or a fraction thereof. The top 10 holdings of an index fund is usually listed to give you an idea of where the fund invests a good portion of its money in. This can give you relevant information about the index fund's financial health or investment strategy. 

The bottom line

Investing in index funds is a low-cost way to build a diversified portfolio and minimize risks. When selecting an index fund to invest in, there are many important factors to consider. For a novice investor, an index fund's performance, expense ratio, investment minimum, overall rating and returns, net asset value (NAV), and the fund's top 10 holding, among other things, should serve as a good starting point. An investor is encouraged to evaluate all the aforementioned parameters before selecting an index fund. 

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