How I Evaluate and Select Index Funds

16836490731_78fc86d8e3_kIn a world where there are investment options galore, where do you even begin?! When it comes to retirement accounts, I’m a passionate advocate of index funds. Index funds are a large pool of stocks or bonds that are managed to track a specific index. They are typically low cost and provide a quick way to diversify your portfolio. I like to think of index investing as putting your retirement accounts on autopilot. Many people may say that index investing is boring or unsexy, but I will tell you that I have felt incredibly sexy watching my retirement portfolio consistently grow over the past decade.

The first place to start is to determine your target asset allocation. In other words, how much of your portfolio do you want invested in stocks and bonds, and what types of stocks and bonds do you want to own to ensure diversification? Take a look at my prior post on diversifying and balancing a portfolio. It details the exact asset allocation that I use for my wife and my retirement accounts. Now that you have an idea of what types of investments you need in your portfolio, let’s review a few key pieces of information that I evaluate when looking at a specific index fund. We’ll focus on one of my favorite index funds today, Fidelity’s Spartan 500 Index fund (FUSVX).

Expense Ratio:

Unless you’re investing in individual stocks (which I would caution against), every mutual fund, index fund, ETF, etc. will charge you fees for investing your money. Basically the fund manager is managing an overall fund and charges each investor who buys shares of the fund. So how do you determine exactly how much you’re paying? The answer is the expense ratio. Each fund will state an expense ratio which tells you what percentage of your average investment balance you will pay in investment expenses. Notice the expense ratio that’s circled for FUSVX.

This expense ratio indicates that I’m paying .07% to own shares of this particular fund. In other words, I pay about $.70 for every $1,000 invested.

For me, the expense ratio is the first thing that I look at when comparing funds. You can’t control whether the market will go up or down, but the one thing that you can control is the expenses that you pay. Even minor changes in your investment expenses (and therefore your total returns) can have incredible impacts on your lifetime investment earnings. Take a look at my post on why investing is not like gambling to see a breakdown of the impact that a seemingly minor change of 1% in your investment returns can have on your nest egg. So, when all else is equal always select the investment with the lowest expense ratio. I typically invest in index funds, which aren’t as actively managed as a typical mutual fund. Because the fund manager isn’t actively buying and selling shares in the fund (and therefore working less) the expenses are much lower. Index funds typically track a certain market index and mirror the returns of the index as a whole. Look at one of my favorite fidelity funds, the Spartan 500 fund. It tracks the S&P 500 and has an expense ratio of just .07%… Amazing!


Past Performance:

Let’s face it, the investing world is full of predictions of the future. Every investor feels that they can anticipate the next emerging market or establish a winning portfolio. At the end of the day, history can be the best predictor of future performance. That’s why I always take a look at the past performance of a prospective investment. What has it done YTD? How about over the past 3, 5 & 10 years? I like to look for funds that have kept up with overall market returns. If the fund did not keep up with year to year market returns, why not? Was it due to a certain sector downturn or other explainable market driven events?


Analyst Ratings:

Has anyone ever heard on the news that analysts have upgraded or downgraded a stock? Well, typically analyst ratings have a big impact on the price of an individual stock. In its simplest form, large investment firms will have teams of analysts that review internal and external information for a particular company and place a rating on the underlying stock. Therefore, for index funds, an analyst rating is an expert opinion on a particular fund. You’ll see that analyst ratings will vary for any particular fund or stock, and I don’t put too much credence in any single rating. However, I do like to take a look at the Morningstar rating/ranking to see where the fund sits in relation to Morningstar’s evaluation.


Risk Rating

I don’t know about you, but when it comes to my money, I’m fairly conservative. I like to reap the long-term rewards of compound returns without a significant amount of risk in my portfolio. Check out the power of compound returns in my post on why investing is not like gambling. Each index fund will have a risk rating. The rating will be based upon the underlying investments within the fund. A fund comprised of stocks will typically have a much higher risk rating than a fund comprised of government bonds. If the fund is comprised of small cap stocks, it will typically have a much higher risk rating than a fund comprised of large cap stocks. Some of the index funds in your portfolio will have higher risk than others, but overall it is about diversifying your portfolio as a whole and making sure that your entire portfolio balances your risk in relation to your personal risk tolerance. Think of the risk rating as how volatile the fund may be. When there are market swings, higher risk investments will have more volatile price changes in comparison to lower risk investments. You can see below that the risk rating of the Spartan 500 Index fund is just above average. It’s a stock fund which is typically more risky than bonds, however it’s comprised of large cap, blue chip companies.

Picture_Risk Rating

Now What?

Now you’ve successfully evaluated 4 key elements of an index fund. Remember, to evaluate the index funds within your target asset allocation as explained in my post on how we diversify and balance our portfolio. Make sure you establish a diversified portfolio by investing in quality index funds and you will be well on your way to maintaining a strong retirement portfolio and becoming a true financial superhero.


Photo by GotCredit

No Nonsense Landlord
No Nonsense Landlord

I have been buying IVV, which is basically the same as FUSVX.  Factor in a bit more med and tech with IVW and GHLC, and some IWM, QQQ.  Some dividends with DVY and 100 shares of GLD, and that is my portfolio.  I never should have bought the GLD...  I also have 100 shares of PFG that I got as part of "go public" deal.

Financial Tour Guide
Financial Tour Guide moderator

@No Nonsense Landlord Looks like you have some great diversification built into your portfolio.  I've found that diversification gives your portfolio consistency and balance whether the market is going up or down.


There is something - no, make that a lot - to be said about low-cost index funds. I always suggest people look for funds with an expense ratio < 1%. 

Financial Tour Guide
Financial Tour Guide moderator

Absolutely. Low expense ratios make a huge difference. I've actually been comparing fidelity index funds vs. vanguard and may transfer my retirement accounts to vanguard because the expense ratios are a bit lower.

DC @ Young Adult Money
DC @ Young Adult Money

Great post!  I go through the same process when I'm evaluating funds in my 401k account.  I love low expense ratios!

Financial Tour Guide
Financial Tour Guide moderator

@DC @ Young Adult Money The expense ratio is the first thing that I evaluate when reviewing a fund.  Investment expenses have such a big impact on overall returns, especially in a 401K where there can be a number of administrative and plan fees.