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Index funds are a great investment for building wealth over the long-term. That's one reason they're popular with retirement investors.
What is an index fund?
An index fund is a group of stocks that aims to mirror the performance of an existing stock market index, such as the . An index is made up of companies that represent a part of the financial market and offers a look into the health of the economy as a whole.
An index fund will be made up of the same investments that make up the index it tracks. This way, the performance of the index fund usually closely mirrors that of the index, with no hands-on management necessary.
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How do index funds work?
Index funds don’t try to beat the market, or earn higher returns compared to market averages. Instead, these funds try to be the market — by buying stocks of every firm listed on a market index to match the performance of the index as a whole.
Because of this, index funds are considered a passive management strategy. That means they don't need to actively decide which investments to buy or sell. Index funds are often used to help balance the risk in an investor's portfolio, as market swings tend to be less volatile across an index compared with individual stocks.
Why invest in index funds?
Despite the fact that fund managers do a lot of work to "beat the market" (namely, a market index), they very rarely do. And if they do, it's highly unlikely that they will continue to beat the market over the long term.
According to SPIVA, which is a part of S&P Global, only 29% of actively managed funds beat the S&P 500 in 2019. In 2021, only 9% of those funds continued to beat their benchmark.
Actively managed funds often underperform the market, while index funds match it. As a result, passively managed index funds typically bring their investors better returns over the long term. Plus, they cost less, as fees for actively managed investments tend to be higher.
What is an index?
For investors, an index is a group of securities, such as stocks, that are used to measure the health of the broader market. When you hear newscasters talk about the ups and downs of "the Dow," they are talking about how well a specific index — the Dow Jones Industrial Average — performed that day.
As the name suggests, an index fund tracks a particular benchmark index. Some common benchmarks for index funds include:
Index examples
The S&P 500: As noted above, Standard & Poor's 500 is an index of the 500 largest U.S. public companies.
The Dow Jones Industrial Average: This well-known index (also known as the DJIA) tracks the 30 largest U.S. firms.
Nasdaq: The Nasdaq Composite tracks more than 3,000 tech stocks.
Russell 2000 Index: The Russell 2000 tracks 2000 smaller companies. (They're also known as "small caps," referring to companies with market capitalization of less than $2 billion).
The Wilshire 5000 Total Market Index: The Wilshire 5000 tracks the nearly 7,000 publicly traded U.S. companies. It's weighted by capitalization.
The MSCI EAFE Index: Tracks performance of large- and mid-cap stocks of firms based in 21 developed nations outside the U.S. and Canada. It includes nations in Europe, Australasia and the Far East.
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How much do index funds cost?
Index funds have fewer fees that erode your returns than actively managed funds. That's because they require less work than managed accounts. You're not paying for someone to study financial statements and make calls on what to buy. Index funds may be less expensive than other funds, but they can still incur some costs. Here are the important ones:
Investment minimum. The minimum required to invest in a mutual fund can run as low as nothing or as high as a few thousand dollars. Once you’ve crossed that threshold, most funds allow investors to add money in smaller amounts.
Account minimum. This is different than the investment minimum. Although a brokerage's account minimum may be $0 (common for customers who open a traditional or Roth IRA), that doesn’t remove the investment minimum for a particular index fund.
Expense ratio. This is one of the main costs of an index fund. Expense ratios are fees that are subtracted from each fund shareholder’s returns as a percentage of their overall investment. Find the expense ratio in the mutual fund’s prospectus or when you look up a quote for a mutual fund on a financial site.
Tax-cost ratio. In addition to paying fees, owning the fund may trigger capital gains taxes if held outside tax-advantaged accounts, such as a 401(k) or an IRA. Like the expense ratio, these taxes can take a bite out of investment returns.
Diversifying with index funds
Index funds are available across a variety of asset classes. Investors can buy funds that focus on companies with small, medium or large capital values. Other funds focus on a sector, like technology or energy. These indexes are perhaps less diversified than the broadest market index, but still more so than if you were to buy stock in a handful of companies within a sector.
Individual stocks may rise and fall, but indexes tend to rise over time. With index funds, you won’t get bull returns during a bear market. But you won’t lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.
» DIVE DEEPER: Learn how to invest with Vanguard index funds.
Quick start guide: How to invest in index funds
Investing in index funds is easy. Here's a quick rundown of how to do it:
1. Have a goal for your index funds
Before you start investing in index funds, it's important to know what you want your money to do for you. If you're looking to make a mint in a few years and are willing to take a lot of risk, you may be more interested in individual stocks or even cryptocurrency.
But if you're looking to let your money grow slowly over time, particularly if you're saving for retirement, index funds may be a great investment for your portfolio.
2. Research index funds
Once you know what index you want to track, it's time to look at the actual index funds you'll be investing in. When you're investigating an index fund, it's important to consider several factors. Here are some things to keep in mind:
Company size and capitalization. Index funds can track small, medium-sized or large companies. (These funds are also known as small-, mid- or large-cap indexes).
Geography. There are funds that focus on stocks that trade on foreign exchanges or a combination of international exchanges.
Business sector or industry. You can explore funds that focus on consumer goods, technology, health-related businesses.
Asset type. There are funds that track bonds, commodities and cash.
Market opportunities. These funds examine emerging markets or other growing sectors for investment.
Despite the array of choices, you may need to invest in only one. Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio. (That might mean more emerging market exposure, or a higher share in small companies or bonds.)
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3. Pick your index funds
At this point, it's time to choose which corresponding index fund to buy. Oftentimes, this boils down to cost.
Low costs are one of the biggest selling points of index funds. They’re cheap to run because they’re automated to follow the shifts in value in an index. However, don’t assume that all index mutual funds are cheap.
They still carry administrative costs. These costs are subtracted from each fund shareholder’s returns as a percentage of their overall investment.
Two funds may have the same investment goal — like tracking the S&P 500 — yet have management costs that can vary wildly. Those fractions of a percentage point may seem like no big deal, but your long-term investment returns can take a massive hit from the smallest fee inflation. Typically, the bigger the fund, the lower the fees.
4. Decide where to buy your index funds
You can purchase an index fund directly from a mutual fund company or a brokerage. Same goes for exchange-traded funds (ETFs). These are like mini mutual funds that trade like stocks throughout the day (more on these below).
When you're choosing where to buy an index fund, consider:
Fund selection. Do you want to purchase index funds from various fund families? The big mutual fund companies carry some of their competitors’ funds. However, the selection may be more limited than what’s available in a discount broker’s lineup.
Convenience. Find a single provider who can accommodate all your needs. For example, if you’re just going to invest in mutual funds (or even a mix of funds and stocks), a mutual fund company may be able to serve as your investment hub. But if you require sophisticated stock research and screening tools, a discount broker that also sells the index funds you want may be better. (If you don't have a brokerage account, here's how to open one.)
Trading costs. If the commission or transaction fee isn’t waived, consider how much a broker or fund company charges to buy or sell the index fund. Mutual fund commissions are higher than stock trading ones, about $20 or more. Compare that with less than $10 a trade for stocks and ETFs.
Impact investing. Want your investment to make a difference outside your portfolio? Some funds target companies with a focus on environmental or social justice causes. Learn more about impact investing.
Commission-free options. Do they offer no-transaction-fee mutual funds or commission-free ETFs? This is an important metric we use to rate discount brokers.
» Need help? Here's how to open a brokerage account
5. Buy index funds
In order to purchase shares of an index fund, you'll need to open an investment account. A brokerage account, individual retirement account (IRA) or Roth IRA will all work. You can then buy the fund in the account.
When you go to purchase the fund, you may be able to select a fixed dollar amount to spend or choose a number of shares. The share price of the index fund, and your investing budget, will likely determine how much you're willing to spend. For instance, if you have $1,000 you'd like to invest in an index fund, and the fund you're looking at is selling for $100 a share, you'd be able to purchase 10 shares.
» Want to cut to the chase? See our picks for best brokers for mutual funds.
6. Keep an eye on your index funds
Index funds have become one of the most popular ways for Americans to invest because of their ease of use. Their diversity — and returns that typically beat actively managed accounts — don't hurt, either. But passive management doesn't mean you should completely ignore your index fund. Here are some things to think about over time:
Is the index fund doing its job? Your index fund should mirror the performance of the underlying index. To check, look at the index fund’s returns on the mutual fund quote page. It shows the index fund’s returns during several time periods, compared with the performance of the benchmark index. Don’t panic if the returns aren’t identical. Remember, those investment costs, even if minimal, affect results, as do taxes. However, red flags should wave if the fund’s performance lags the index by much more than the expense ratio.
Is the index fund you want too expensive? If the fees start stacking up over time, you may want to reevaluate your index fund.
Want to buy stocks instead? If you want to be hands-on with your investments, you may want to explore stocks. Learn how to buy stocks with these step-by-step instructions.
Frequently asked questions
Is now a good time to invest in index funds?
Whether the market is down or up, as long as you're investing for the long-term in a well-diversified portfolio it’s as good a time as any. If the market is down, it's essentially on sale, and you may be able to pick up an index fund for less money.
Is investing in index funds dangerous?
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time. You may then be able to sell that investment for a profit — especially if you purchase that index fund when the market is down.
Are index funds good for beginners?
If you’re planning to invest for the long-term, dips or highs in the market become less relevant. If you’re worried about buying an index fund at a high, keep in mind that if you’re invested in that fund for many years, that high will look much smaller down the road. Check out our investment calculator to explore how an investment in an index fund or other security could grow over time.
Are index funds popular?
Since the first index fund was introduced in 1976 index funds have become incredibly popular. Currently, investors are pulling their money out of actively managed funds and investing more heavily in U.S. stock index funds. According to Morningstar, actively managed funds lost $926 billion in 2022 while passive funds gained $556 billion.
Neither the author nor editor held positions in the aforementioned investments at the time of publication.
