How to Pick the Best Index Funds

Learn the Basics on Finding the Best Index Funds

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How do you find the best index funds?. Getty Images

Many investors associate the best index funds with the lowest expense ratios or mutual fund companies like Vanguard Investments. While this association isn't completely incorrect, the best index funds aren't limited to just low costs and indexing pioneers.

Before we get into the particular traits that make the best index funds, let's cover the basics of what index funds are and how they work.

What Is An Index and How Do Index Funds Work?

An index, with regard to investing, is a statistical sampling of securities that represent a defined segment of the market.

For example the S&P 500 Index, is a sampling of approximately 500 large capitalization stocks. But you can't actually invest in an index. This is where mutual fund companies come into the index picture.

An index fund is a fund that buys and holds most or all of the securities that are in the particular index the fund wants to track. This is how and why John Bogle started Vanguard. After noticing that many investors, including professional money managers, were not able to outperform the major market indices, especially in the long run, he decided to create Vanguard 500 Index (VFINX), which would mirror the performance of the S&P 500.

How to Identify and Buy the Best Index Funds

To track the index closely, it is important to keep costs low. Fortunately, since index funds are passively managed, there is very little research, analysis, or trading that occurs. Therefore, by nature, index funds are cheap funds to operate and own.

So the primary trait of the best index funds is low expense ratios. But that's not all there is to finding the best index funds!

If you think for a brief moment, you may be able to guess the other major trait. If index funds seek to track the benchmark index, how do they structure the portfolio? How do they know precisely which securities to buy and how many shares they need to own in order to track the index as closely as possible?

The other trait of the best index funds is low tracking error, which is a measure of an index fund's effectiveness in replicating or "matching" the performance of the benchmark index.

While expense ratios for mutual funds are publicly shared and easily found, tracking error isn't something that you'll find publicly displayed. Therefore, when searching for the best index funds, you'll start by looking for the lowest expense ratios. Once you narrow your search down to a few, you can then look at the actual past performance of each fund and compare it directly with the respective index.

Then you'll have your best index fund!

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.