Simplicity and low costs have made index funds a popular option with individual investors in recent years. Using a broad market index fund, an investor can attempt to replicate the returns of the overall stock market without having to take on the cost and risk of buying and selling individual stocks.
“It's effectively a way to invest and have market exposure,” says John DeYonker, Titan’s head of investor relations. However, index funds can work in different ways, and there also are costs associated with buying and holding index funds.
What is an index fund?
An index fund is a type of fund that tries to mirror the performance of a benchmark market index, such as the S&P 500 stock market index. Investors can use a brokerage or retirement account to purchase exchange-traded funds (ETFs) or mutual funds that track indexes.
Because index funds can track price changes in hundreds or thousands of stocks (or other securities), they may help investors create a diversified portfolio. Index funds also tend to have lower fees than actively managed funds, which can increase an investor’s returns.
As with any type of investment, index fund investing can be risky. Some index funds may be narrowly focused and won’t provide the diversification that some investors might want. Also, the index fund will track both the ups and downs of its benchmark index.
How to invest in index funds
Index ETFs and mutual funds can be bought and sold like other types of investments. The process often involves the following steps:
1. Open an investment account
Similar to investing in stocks for the first time, investors may need to open a new account to invest in index funds, such as a:
- A standard brokerage account.
- Tax-advantaged individual retirement account (IRA) or Roth IRA.
- An employer-sponsored retirement account, such as a 401(k).
- An account directly with a mutual fund company.
The index fund options and fees could vary depending on the account type. There may also be different tax implications for investing within a tax-advantaged account.
2. Pick the underlying index
Indexes are the benchmarks that index funds try to track. But indexes themselves can be created to track different types of investments, such as stocks or bonds.
Even within a subgroup, such as stock market indexes, there may be hundreds of options. Several well-known stock market indexes include:
- The Dow Jones Industrial Average, which tracks 30 of the largest US companies.
- The S&P 500, which tracks 500 of the largest companies in leading industries in the US.
- The Russell 2000 Index, which tracks 2,000 small-cap US companies.
There are also index funds focused on a specific industry, such as solar energy, or tracking companies from particular regions. These may be riskier than broad index funds but less risky than investing in individual companies.
3. Choose an index fund
There may be multiple index funds trying to track the same underlying benchmark index, especially for well-known indexes. While they might all try to replicate the same ups and downs, investors will have to decide which they want to invest in. The first decision is between an ETF or a mutual fund. From there, investors can evaluate each fund available.
Some criteria they sometimes use are:
- Minimum investment requirements. Investment minimums might not be an issue for ETF index funds, especially for investors who can buy fractional shares. However, index mutual funds may require an initial investment of several thousand dollars.
- Expense ratios. Fund expense ratios cover the fund’s operating costs and are the primary expense that investors often compare. Two funds that track the same index may have varying fees.
- Other fees. There may be other fees to compare as well, including 12b-1 marketing fees and load fees—essentially commissions for buying and selling the fund. And there may be trading costs to buy or sell ETFs, although those depend on the investment account rather than the ETF itself.
- The fund’s holdings. Index funds may have a stated purpose or goal, but investors may want to track their holdings to make sure they align with the investor’s objectives. This may be particularly important for environmental, social, and governance (ESG) funds.
Some investors consider other criteria as well. For instance, an index ETF may be more tax-efficient than an index mutual fund because an ETF’s underlying assets are often bought and sold less frequently, leading to fewer taxable events.
4. Purchase the shares
It’s now time to buy the index fund. Index ETFs can be bought and sold throughout the trading day like stocks, while mutual funds are traded once per day after the markets close. In either case, investors usually consider the current price, requirements, and fees when buying.
FAQs about index funds
Can index fund investors lose their entire investment?
Investing in an index fund can be risky, and an index fund investor could lose their entire investment. But it’s not likely because index funds often track a wide range of underlying investments, providing diversification and lower risk.
What’s a good expense ratio for an index fund?
Index funds tend to have lower expense ratios than actively managed funds. The Investment Company Institute (ICI) reports index equity ETFs had an average expense ratio of 0.18% in 2020. It was slightly lower (0.13%) for index bond ETFs. Index equity mutual funds had an even lower average expense ratio of 0.06%.
What are low-cost index funds?
Low-cost index funds are index ETFs or mutual funds that have especially low expense ratios or other fees. There are some index mutual funds that don’t charge any fees at all. These funds could yield higher net returns than similar funds that charge a fee.
What is the average return for an index fund?
Because index funds can track different benchmark indexes, there isn’t an overall average return. The average historical stock market return has been about 10.7% a year, or 7% after accounting for inflation. A broad index fund that tracks the overall stock market could offer a similar return.
Other investment options
Putting money into a passive index fund isn’t the only way to invest, nor is it necessarily the best for everyone. Other options include:
- Individual stocks and bonds. Investing in individual companies and bonds may be riskier, but it can also lead to more returns.
- Actively managed funds. Rather than buying passive index funds, some investors purchase actively managed funds. These tend to have higher expense ratios, but the fund managers also try to buy and sell investments to outperform (rather than match) an underlying benchmark.
- Work with an advisor. An investment advisor, either an individual or firm, sometimes manages investments on behalf of clients. The advisor may suggest a mix of stocks, bonds, index, and actively managed funds.
There are also investment opportunities beyond stocks and bonds. Some investors these days put money into cutting-edge options, such as cryptocurrencies, while others gravitate toward other traditional investments, such as real estate.
The bottom line
Index fund investing can be a low-cost and simple way to try and capture the overall market’s returns or diversify investments within a more focused niche. However, investors still need to compare different index fund options and consider the risk they’re taking on.