Top ten tips and tricks for investing in index funds and ETFs

At first glance, passive investing seems pretty straightforward – you buy a fund that tracks a bunch of stocks (a sector, a theme, or a whole market index) and you pay a low fee while letting the market do its thing. Seems simple enough.

Problem is, as passive investing has exploded in popularity, so have the number of investments available. There are now tons of different index funds and ETFs, which means more opportunities – but also more potential pitfalls if you’re not paying attention.So, here are ten tips for investing in index funds and ETFs.

Rule 1: Don’t overpay. Investment management firms charge different amounts for the essentially same thing. So doing a little research on the cheapest funds available could help you find some real savings.Let me give you an example: the SPRD S&P 500 ETF (SPY) costs 0.09% in annual fees, but the Vanguard S&P 500 ETF (VOO) charges just 0.03%, making it one of the cheapest ways to invest in the index.Let’s assume that over a 25-year period, both delivered the same returns – roughly 5% a year. And let’s assume you invested a lump sum of $50,000 at the beginning of that period. The SPDR ETF would leave you with $165,727 in the end, with $3.591 taken for the fund fee. The Vanguard fund, by contrast, would leave you with $168,112, with just $1.205 paid in fees. That’s an extra $2,385 in your pocket, instead of someone else’s.

Rule 2: Look under the hood of a strategy. While price matters, you’ll want to look closely at the index a passive fund tracks – there can be key differences between similarly labeled funds.The iShares MSCI ACWI ETF USD (SSAC) and the iShares Core MSCI World ETF USD (SWDA) look a lot alike, but they own different companies. The former is an “all country” tracker that includes emerging market stocks, while the latter steers clear of emerging market assets.Investors could also be tripped up by sustainable passive funds that own stocks that might not meet their personal responsible investment standards. For example, Vanguard ESG US Stock ETF (ESGV; 0.9%) owns shares in Facebook parent Meta, though some would say the firm doesn’t demonstrate the best ESG (environmental, social, and governance) standards. Some sustainability passive funds, meanwhile, own oil companies – typically because of their investments in renewable energy.

Rule 3: Check if a fund is market-cap or equally weighted. Most passive funds are “market cap” weighted – which means they buy more of a company as it grows larger – but some are “equal” weighted, with each company making up the same proportion of the total. That might seem like a cosmetic difference, but it’s not. In fact, this factor can have serious consequences for performance. The dominance of America’s biggest technology companies over the past decade has meant that funds that bought more of them as they grew larger performed best.The S&P 500 is up around 124% over five years, while the equally weighted version is up 114%. However, if cheap stocks make a comeback and big expensive ones falter, an equally weighted fund could reward investors. US investors could consider the Invesco S&P 500 Equal Weight ETF (RSP; expense ratio: 0.2%) while investors elsewhere might consider the Xtrackers S&P 500 Equal Weight UCITS ETF (expense ratio: 0.25%).

Rule 4: Check how closely a fund follows its index Buying a fund that closely tracks its index is another important consideration. There are two measures to watch here: tracking difference and tracking error.Tracking difference is the drag on performance produced by elements such as management fees, rebalancing costs, cash drag, and dividend distribution. Tracking error is a calculation that looks at the consistency and volatility of the difference between a fund and its benchmark over time. Big tracking errors or tracking differences should be seen as a red flag – potentially signaling that the ETF in question incurs excessive trading costs (maybe because of the complexity of its strategy) or that the asset management firm running the ETF is charging high fees.

Rule 5: Make sure you understand industry jargon. Thematic, factor, ESG, synthetic: the passive investment world is full of industry jargon that can lead investors into the wrong fund. So take the time to read about a strategy and truly understand it.Factor funds (also known as smart beta funds) can be particularly tough for beginner investors to get their heads around. Those funds buy stocks that display certain characteristics – such as cheap share prices relative to earnings, or above-average dividend yields. This allows investors to replicate an investment style, sometimes for cheap.

Rule 6: Watch out for expensive thematic funds. A growing area for passive investment has been “thematic” funds, which buy companies involved in niche business areas, such as artificial intelligence (AI) or clean energy.However, some of these hot strategies charge investors even more than an active manager would, which is a potential red flag for investors if the fund does not deliver the goods.For example, the HANetf EMQQ Emerging Markets Internet UCITS ETF (EMQQ) charges 0.86%.

Rule 7: Check if a tracker owns physical assets or financial contracts. A physical ETF buys the shares of the underlying index it’s supposed to mirror. In contrast, synthetic ETFs don’t own stocks, bonds, or commodities, but instead buy financial contracts that replicate the price of them. That means that investors can pay less for the funds, but they might run into trouble in a financial crisis if the bank that provides the derivatives collapses. It’s what’s known as “counterparty risk.”Investors in gold should pay extra attention to this. While some funds track the price of gold, others buy actual bars of the stuff. For those, you can consider the SPDR Gold Shares (ticker: GLD; expense ratio: 0.4%), iShares Gold Trust (IAU; 0.12%), or, for non-US investors, the Invesco Physical Gold ETC (SGLS; 0.34%).

Rule 8: Be careful with bond tracker funds. Unlike stock market passive funds that tend to buy more of companies as they grow larger (and more successful), bond funds have their biggest positions in companies or countries with the most debt.This could be interpreted as a reason not to invest, as companies with more debt may be less secure financially. On the other hand, actively managed funds can avoid companies that are heavily in debt and focus on more financially secure firms.

Rule 9: Don’t use index funds for short-term trading ETFs are listed on stock exchanges, and that means investors can trade shares when markets are open. That’s great for folks who want to quickly move in and out of an investment.Index funds, on the other hand, typically execute their day’s trades all at once, usually at the end of the market day, so you may face delays when you put an order in. Now that might not be an issue for regular savers and those with a long-term mindset, but day traders are better served by ETFs.

Rule 10: Be careful with leveraged ETFs. Leveraged ETFs give the investor multiple times the return of the index. The WisdomTree FTSE 100 3x Daily Lvrgd ETP, for example, provides triple the daily return of the FTSE 100.Investors should be careful with these though. The funds can see big potential gains, sure, but they can also see huge losses. Even the promotional literature for leveraged products advises against holding these assets for more than a day.o3-mini

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