The main reason why many investors prefer investing in index funds is that they offer diversification. The key to having a healthy investment is diversification. It helps you maintain a balance in your investment. If one type of security fails, others are there to support the downfall.
Now, the question with the diversified investment arises: How much of it must one own? The number of index funds to be acknowledged is determined by the type of index fund. The strategy that a trader/investor is following also helps determine the numbers. It is beneficial to own numerous index funds. However, sometimes investing in a single one can also be worthwhile.
There are two types of index funds — mutual funds and ETFs (Exchange Traded Funds). Both of them are pooled funds that are invested in a portfolio of diversified securities. However, they are different in many aspects and have distinct benefits and drawbacks.
Read this article to understand more about the different types of index funds and how traders can prepare a successful portfolio using index funds.
How Many Index Funds Should I Own?
Usually, average investors own from 3 to 10 index funds. However, there is no particular number of index funds that you should own. Long-term investors very often own only one index fund. If you own too many funds, that can create an expensive approach.
Determining the Number of Index Funds To Invest In
The type of index funds and the strategy and goals of the investment determines the number of index funds one must own. We will discuss both aspects in this article, but first, let’s understand a bit of the different types of index funds.
There are two basic categories of Index Funds; Mutual Funds and Exchange Traded Funds (ETFs). Both are pooled funds investments, but they have a few differences. Exchange-Traded Funds are a group of securities that can be traded on an exchange during trading hours. On the other hand, Mutual Funds are a group of securities traded after the market closes.
Technically, investors should include fewer mutual funds and more ETFs in their investment portfolios. The rationale behind this statement is that mutual funds cover a broader collection of securities compared to ETFs that are typically focused on a particular sector or index.
If we look at ETFs, they have certain advantages over mutual funds, like they are more flexible and incur lower costs than mutual funds. ETFs are handled passively as they are traded on an exchange, while mutual funds are actively managed as they can only be bought once the market’s operational hours have ended.
Let’s get to the point and see how the attributes of these index funds determine your investment strategy.
How many Mutual Funds To Invest In
If you ask for a number, then there is none. You cannot determine the exact number of mutual funds you should hold. That is generally the difference between mutual funds and ETFs. Typically, there should be fewer mutual funds and more ETFs in your investment portfolio. Sometimes even one is sufficient.
Holding fewer mutual funds may feel absurd as it has always been said that diversification is the reason behind a successful investment. Then why should one hold fewer mutual funds when it is the most diversified investment? This will become clear once you know how mutual funds work.
Investing in mutual funds means that you own the fund and its profits. Your fund manager will continuously work towards generating more profits by actively buying and selling the securities included in the fund’s portfolio. Since the workforce managing your funds is more active, there are higher costs involved in managing the mutual funds. The additional cost is an essential factor to consider when determining the number of mutual funds to include in your investment.
Generally, the cost of mutual funds falls between some hundred dollars to some thousand dollars for one share. If we take an example, VTSAX has typically set $3,000 as the minimum buy-in. A $3,000 entry-point is very high for the majority of traders. Therefore, many will not include more mutual funds in their investment at such a high cost.
Reason Behind Including Less Mutual Funds
The objective of including mutual funds in your investment is to diversify them. One mutual fund completes the task of diversifying your investment as it is already highly diversified. An important thing to mention here is that mutual funds change according to the market and are managed actively.
If we talk about index funds, like VTSAX, they are entirely diversified. The reason behind it is that they cover the whole US equity market or significant indices (S&P 500) to bring diversified mutual funds to investors. With mutual funds already being too diversified, it is not wise to increase the diversification by adding more mutual funds.
Also, the fund’s manager is constantly working towards increasing the profit potential of the mutual funds by buying and selling them. Therefore, fewer mutual funds, or maybe just one, are good enough to increase the profits. Instead, investors can plan on buying more ETFs.
If we look at history, there is evidence of the risk mitigation potential of mutual funds. It has a consistent record of generating profits. Even some of the leading investment companies consider it the same. Therefore, it is wise to include less or one mutual fund in your investment.
How many ETFs To Invest In
Investors should certainly have more ETFs than mutual funds, but how much? The typical recommendation is between 5 and 10. However, your trading strategy and the funds (type of ETFs) you plan to invest in will determine the number of ETFs you should own.
The general reason behind including more ETFs is their narrow scope. ETFs are also cheaper due to passive management. They do not have the same growth potential as a single mutual fund has. That is why including more ETFs is a better decision.
Since ETFs are traded like stocks on an exchange, most brokers allow you to buy various stocks. However, most traders may not allow you to buy and sell options for ETFs, so you may have to check with your broker if you are planning to do so.
Reason Behind Including More ETFs
Different types of ETFs are available to invest in. Each ETF focuses on a particular market, index, or security category. ETFs are diversified, but not as much as mutual funds. This is the reason they have a narrow scope. Each ETF would cover a lesser part of the market than mutual funds that cover a wider part.
ETFs fundamental is based on growth in the longer term. Their growth is relatively closed and consistent, and hence their management is not as active as mutual funds. They are passively managed. Therefore, including more ETFs in your investment would allow you to maintain a balance with the ever-changing market.
Effect of Trading Strategy on the Number of Index Funds
The different aspects of the index funds cannot ascertain the number of each fund you need to involve in your investment. Individual objectives play a significant role in determining the number of mutual funds. It is because your investment goals give the direction to your investment strategy. As per that strategy, the types of funds and their quantity are determined by the investment.
For instance, if you wish to be involved directly in managing funds, then ETFs are suitable. On the other hand, you can go for mutual funds if you are okay with a fund manager actively working your funds. Both the index funds have their advantages, and investors can invest in a combination of both funds. Many experienced investors create an investment portfolio that includes ETFs and mutual funds according to their individual investment goals.
Let’s look at two situations where investors can benefit from index funds.
Mutual funds can handle frequent fund transfers. Investors can deposit every month in a single mutual fund. This is common amongst retirement accounts where the funds added to the retirement accounts are invested in mutual funds. The fund manager manages these retirement accounts and actively invests in these funds.
Since mutual funds can generate better results in the long term, well-managed mutual funds can gradually grow your retirement funds. However, mutual funds may not be an option for investors who are not planning to make frequent deposits or aiming towards long-term goals.
The price movement of ETFs is more frequent as they are listed on an exchange. If the traders are skilled enough, they can profit from these price movements and won’t require the funds for frequent deposits. For this strategy, you will need a more diverse portfolio, and for that, you can select a combination of different ETFs.
Your Involvement in the Trade
The type of index you want to invest in depends on how much you want to be involved in its trading.
If you wish to invest, generate profits for a more extended period, and do not want to get involved too much in the trading matter and eat the ripened fruit at the end, then a few mutual funds are best suitable for you. Since the funds manager actively manages these funds, your involvement is unnecessary. These managers are experts in their field and get paid for accomplishing your investment goal.
On the contrary, if you wish to trade your funds actively, buying a variety of ETFs would be a better option. With ETFs, you can handle your funds independently and require you to stay focused because of the frequent price changes. They are exchange-traded and, therefore, you wouldn’t want to miss out on better opportunities.
If you are looking for an exact number of index funds you must own for better results; you should know that the number doesn’t exist. Your investment goals, trading strategy, and the type of index funds can help you determine the number more accurately. Analyze these factors and find the perfect number yourself.