Buying shares of an index fund can be an effective way to get started in the market. Index funds are widely available and simple to buy, and they also typically come jampacked with a number of other investment advantages, including that they:
- Are usually very cost-effective
- Tend to outperform actively managed funds over time
- Generally offer an easy way to diversify a portfolio, which can reduce some of the risks associated with buying individual stocks and bonds
But first, let’s start with the basics. What is an index fund and how does it work?
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF), which is a pooled investment portfolio filled with stocks, bonds, or a combination of the two. A mutual fund or ETF has a stated investment purpose, which guides the fund’s strategy, including any buy-and-sell decisions.
Mutual fund management styles typically fall within two categories: active or passive. Active management seeks new investment opportunities — an up-and-coming company, for example, or one that’s down on its luck and poised for a future rebound. Either way, the manager of an active fund has a goal of identifying companies that will outperform the broader market over time.
Index funds fall within the passive management bucket. This is where a fund aims to replicate the market returns of a particular benchmark or market index. So where an actively managed fund aims to beat market performance, an index fund simply wants to keep pace with a particular index.
Some well-known investment indices include:
- Standard & Poor's 500: The S&P is commonly used as a broad gauge for the U.S. stock market, this index tracks the performance of the 500 largest public companies in the nation.
- Dow Jones Industrial Average: The Dow is one of the most commonly followed stock indexes, though it tracks only the performance of 30 large industry-leading companies.
- Russell 2000 Index: This index measures the small-cap stock market by tracking approximately the smallest 2,000 U.S. companies that make up the broader Russell 3000 Index.
- MSCI EAFE Index: This index follows large- and mid-sized companies across 21 developed nations outside the United States and Canada.
- Bloomberg Barclays Aggregate Bond Index: The Agg tracks the overall investment-grade bond market, including corporate, treasury, government, and mortgage-backed bonds.
An index doesn’t buy or sell any securities. Instead, it simply follows the movements of a particular slice of the investment market and reports the results. Index funds, meanwhile, buy and sell securities in a way that mirrors the movements of a particular index. In short, you can’t buy an index, but you can invest in index funds.
Some of the best-known index funds include:
- Vanguard Total Stock Market Index Fund (VTSMX): Offers broad exposure to the entire U.S. equity market, including large-, mid-, and small-sized companies.
- Fidelity 500 Index Fund (FXAIX): Invests in companies tracked by the S&P 500 index, which tracks the 500 largest publicly traded stocks within the U.S.
- Vanguard Total World Stock Index Fund (VTWSX): Offers exposure to companies around the globe, including developed and emerging markets, as well as the U.S. and Canada.
There are index funds that track pretty much any segment of the market, from real estate investment trusts to companies located in emerging markets to municipal bonds issued only in the state of California. If there’s a market you want to invest in, there’s a good chance you can find an index fund that tracks it.
Here’s how an index fund works
When it comes to investing money, purchasing index fund shares is one of the easiest ways to get access to a large slice of the overall securities market. That’s because an index fund automatically buys and sells investments as market conditions change. One of the most commonly tracked proxies for low-cost index funds is the S&P 500, so let’s take that as an example.
The S&P 500 follows the 500 largest publicly-traded companies in the U.S. but, as companies rise and fall in profitability, they’re added or dropped from the index. In the past year, for example, long-suffering retailer Macy’s was purged from the index, and Etsy, the increasingly profitable independent marketplace for crafters, was added.
When the S&P swaps out one company for another, the associated investment adjustments to your S&P 500 index fund are automatically handled by the fund manager. There is no effort required on the part of the index fund investor. Additionally, index fund fees are generally minimal because investment decisions are made solely on the basis of whether an investment remains a component of an index.
This low-cost, passive investing approach makes index funds an attractive option for those who don’t want to select or monitor individual stocks or bonds, or who just want to save a few investing bucks.
Benefits of an index fund
- Consistently attractive performance: Index funds are more likely to outperform their actively managed cousins by a margin of seven in 10 during 2019. This is often because actively managed funds generally come with a much higher fee structure in place. Then there are trading fees, which are generally charged to the portfolio every time a security is bought or sold, and which are usually incurred much more often in an actively managed portfolio.
- Built-in diversification: An index fund can track hundreds of stocks or bonds, which means an investor is often exposed to a broader slice of a market. An actively managed fund, meanwhile, requires a person to select, monitor, and make decisions for each and every security considered and eventually selected for a portfolio. For that reason, actively managed funds tend to hold far fewer stocks or bonds.
- Lower cost: There are no sales commissions associated with an index fund and operating expenses tend to be extremely low. For these reasons, index funds tend to have low fees and lower expense ratios when compared to other investment strategies.
- Easy to DIY: It’s easier to run your own portfolio of index funds as long as you take the time to plan out an effective asset allocation strategy. For that reason, many index investors feel confident enough to skip the trip to a financial advisor’s office, choosing instead to manage their own accounts.
Downsides of an index fund
- Less flexible: A human investor has the ability to move swiftly in and out of certain securities or sectors — like energy or manufacturing, for example — during an unexpected market decline. This is not the case with an index fund.
- Potential for underperformance, relative to a benchmark: Sometimes an index fund’s performance doesn’t track accurately to its benchmark. This can occur either because a fund’s composition doesn’t properly reflect that of the benchmark, or because fund fees took a significant enough bite of the portfolio to affect overall performance.
- May require more active investor participation. An investment in just one index fund — an S&P 500 fund, for example — can offer greater exposure to the large U.S.-based corporations, but still doesn’t cover other market segments like international stocks, small-company stocks, or bonds. That’s why many investors choose to invest in more than one index fund, so they can maintain diverse exposure to more than one area of the market. Index investors who don’t work with a financial advisor will most likely have to take ownership of developing and monitoring their own portfolio construction and asset allocation decisions.
How to buy index funds: everything you need to know
It’s no surprise that so many investors want to know how to invest in index funds. They’re a fast, easy, efficient way to gain access to the stock and bond markets. Still, as with all investments, it can help to know how to identify the best index funds so you can stay on top of your money game.
First, know where to buy index funds
Index funds are widely available through a large number of sources, including:
- Directly through a mutual fund family: You can easily log on to your favorite mutual fund provider’s website, set up an account, and make a purchase. Some of the largest index fund companies include Vanguard, Fidelity, and Black Rock.
- Via an investment app like Stash, Robinhood, or Charles Schwab. Some of the best investment apps can easily be downloaded to your phone or another portable device for easy index fund buying or trading.
- Through a brokerage account or financial advisor, though these options are more likely to incur a higher sales charge or trade commission.
Next, know what to look for in an index fund
Not all investments are created equal. That’s true even for low-cost, easy-access index funds. Here’s what to look for so you can select the index fund that’s the best fit for you:
- Investment minimum: The minimum investment needed to open an account can vary dramatically from one vendor to the next. There’s between a $1,000 and $3,000 account minimum to buy an index fund directly from Vanguard, depending on which share type you purchase. Meanwhile, the same Vanguard index fund can be purchased through an investing app like Ellevest with no account minimum.
- Expense ratios: This is the cost associated with running the fund and includes administrative, management, and advertising fees. The expense ratio is generally very low for index funds (The Vanguard 500 Index Fund has an expense ratio of .14%, compared to .75% for the average actively managed fund) but can vary, which makes it a good number to keep your eye on.
- Fees: Other than the expense ratio, there aren’t many index fund fee traps to fall into, but there can be fees associated with the service you use to purchase your index fund. Keep an eye out for brokerage commissions, financial advisor compensation, or investment app fees.
- Asset class: Index funds generally come in many varieties, which means you can typically find one that tracks whatever slice of the market you want to invest in. That could be large growth-oriented companies, those located within emerging markets, or municipal bonds from the state of California. In short, you get to decide how broad or narrow you want any given slice of the investment market to be.
- Your investment goals: While selecting index funds, it always makes financial sense to keep your overall investment goals in mind. Be sure to select funds that reflect your available time horizon (short-term vs. long-term goals), tolerance for risk, and appropriate asset allocation.
FAQs about index funds
What’s the difference between index funds vs. actively managed funds?
An actively managed mutual fund has a portfolio manager, or team of managers, at the helm to make buy-and-sell decisions on a daily basis. The investment team monitors the existing portfolio for over- or under-performers, looking for ways to either take profit or mitigate loss. Portfolio manager salaries, as well as trade fees, are added to the overall cost of running a mutual fund. Those costs ultimately detract from the overall performance.
An index fund, meanwhile, automatically buys or sells investments only when changes are made to an index the fund tracks. Thus, management fees are typically lower, as are the costs associated with buying and selling securities.
What is the best index fund?
The best index fund is the one that helps meet your personal investment objectives while also offering a low-cost fee structure. A good entry-level investment for many young investors is an index fund that tracks either the total U.S. stock market or the largest 500 U.S. companies.
Can you lose money in an index fund?
All investments are subject to some level of risk, and that includes index funds. Markets rise and fall and the stocks and bonds that make up an index fund’s basket of underlying investments rise and fall along with those markets. And past performance is never a guarantee of future performance.
Still, buying mutual funds is generally considered to be less risky than purchasing individual stocks and bonds. That’s because a mutual fund holds myriad securities — perhaps even hundreds or thousands — which means the rise or fall of one individual stock, or even an entire sector, will have less of an impact on an overall fund than it would on a portfolio that holds only a few securities.
How do beginners invest in index funds?
Even a novice investor can easily dip a toe in the market by purchasing an index fund. Index funds are widely available either directly through a mutual fund company, via an investment app, or by reaching out to a broker or financial advisor.
What’s the bottom line on index funds?
Index funds are a fast, easy, and inexpensive way for even beginner investors to get started in the investment market. Index funds are easy for those who prefer a DIY investing approach. They are also easily available through a financial advisor or investment company if you’d rather work with a partner who can guide you through the process.