Thinking about diving into index funds? They seem to be a favorite among both first-time investors and pros. With low fees, built-in diversification, and a managed approach, index funds make it easy to grow your wealth over time.
Whether you’re thinking about retirement, saving for your children’s education, or just working to build a solid financial future, index funds may be a smart move for you. Here’s a guide on what an index fund is, how it works, and how you can start investing in them.
What Are Index Funds?
Index funds are types of funds, or baskets of securities, that track a market index like the S&P 500 or the Nasdaq, with the goal of mirroring the returns. When you’re talking about index funds vs. mutual funds, an index fund can be a mutual fund, but it also can be an exchange-traded fund (ETF).
- A mutual fund is an investment vehicle that pools money from multiple investors to purchase a mix of investments, such as stocks and bonds. Mutual funds can make it easier to diversify your portfolio, which may help reduce risk. To purchase shares of a mutual fund, you’ll have to buy them through a broker or from the fund itself.
- ETFs are like mutual funds in that they offer convenient diversification with a pooled investment. The key difference is that you buy and sell shares of ETFs through an exchange during the trading day, just as you would trade shares of stock.
How Do Index Funds Work?
Index funds aim to mirror the performance of a specific market index—like the S&P 500 or Dow Jones—by investing in a group of securities that match the index’s makeup. Some index funds invest in all the securities in an index, while others invest in a sample. Weighting is typically based on market capitalization (the total value of a company’s shares), though in some cases, share price determines the weight.
Index funds focus on long-term growth by tracking the performance of a market index, rather than trying to outpace it through frequent trading. To achieve the right proportions, an index fund may use derivatives like options or futures. These tools essentially give investors an indirect way to try to get the same returns as a market index.
Let’s say an S&P 500 index fund wants to match the index exactly, but one of the 500 companies has low trading volume or is difficult to buy in small quantities. Instead of purchasing that stock directly, the fund might use a futures contract that gives it similar exposure.
Why Choose Index Funds?
If you’re looking to build wealth steadily with minimal hassle, index funds may provide a low-maintenance and diversified way to grow your money. Index funds may offer broad market exposure, low costs, and consistent long-term performance. Instead of trying to beat the market, index funds aim to match it by tracking major benchmarks like the S&P 500. This passive strategy helps eliminate the guesswork and high fees of picking individual stocks or actively managed funds. Over time, this approach may outperform most active strategies, especially after fees.
Low Fees and Cost Efficiency
Since they don’t require active stock picking, the expense ratios of index funds are significantly lower—often below 0.10% per year, compared to 0.5% to 1.5% for actively managed funds. Over time, these lower fees can save investors tens or even hundreds of thousands of dollars in compounded returns.
Diversification Made Easy
Index funds can provide instant diversification by spreading your investments across hundreds or thousands of companies. This diversity can reduce risk because you’re not overly exposed to any single stock’s performance.
Long-Term Growth Potential
Historically, the stock market has trended upward despite short-term market volatility. By investing in broad-market index funds, you may capture this growth without the pressure of trying to time the market.
What are the Cons of Index Funds?
Index funds can be a low-cost way to invest in the stock market, but they’re not perfect. Since they simply follow an index, you don’t have much flexibility to avoid underperforming companies. They also won’t give you the chance to beat the market; you’ll only ever match its returns. Plus, when the market dips, your fund will too, and some indexes are heavily weighted toward just a handful of companies or sectors, which can reduce diversification. Keep in mind that you also get less control over taxes, since capital gains distributions can still hit your account even if you haven’t sold anything.
How to Invest in Index Funds
If you’re wondering how to invest in an index fund, it’s pretty simple, even for beginners. You can buy shares of a mutual fund from the fund or through a broker. To buy into an ETF, you can simply buy shares through an exchange, as you would buy stocks. Here’s how to open an index fund:
Step 1 – Choose a Brokerage or Investment Platform
You’ll need a brokerage account to purchase index funds. Many platforms offer commission-free trading for ETFs and low-cost index mutual funds.
Step 2 – Select the Right Index Fund
When choosing the right index funds for your goals, you’ll want to start by looking at the index the fund tracks, such as the S&P 500 or international indexes. Check the fund’s expense ratio; lower is better since fees can eat into your returns over time. Make sure to select funds from a reputable provider with a strong performance history and solid customer service. Also, consider how well the fund tracks its index, called tracking error, and whether it fits your risk tolerance and time horizon.
Step 3 – Open and Fund Your Account
Once you’ve chosen a brokerage, complete the application and link your bank account for deposits. Then you can transfer funds. Many brokerages do not have minimum investments for ETFs.
Step 4 – Place Your Order
Search for the specific index fund you want, then choose how much you want to invest. You’ll typically have the option to place a market order, which buys immediately at the current price, or a limit order that buys only at a specific price. Once submitted, your order executes based on market conditions.
Step 5 – Monitor and Rebalance Periodically
While index funds require little maintenance, it’s good to check annually to determine whether your asset allocation aligns with goals and rebalance if one asset class grows disproportionately.
FAQs
Do index funds pay dividends?
Many index funds distribute dividends from the underlying stocks. You can reinvest them automatically for compound growth.
How do beginners buy index funds?
Open a brokerage account, pick a low-cost index fund, and then fund your account to purchase shares.
How much money do I need to start an index fund?
Some funds, like ETFs, have no minimum, while mutual funds may require $1,000-plus. Many platforms also offer $0 minimum index funds.
Are index funds better than mutual funds?
People often get confused when it comes to index funds vs. mutual funds. But it’s not an either-or scenario. Index funds are mutual funds (or ETFs) but passively managed. They usually outperform actively managed mutual funds due to lower fees.
Are Index Funds Right for You?
Index funds are an excellent choice for long-term investors who want low-cost, hands-off investing, broad diversification, and consistent market-matching returns. However, if you have specific financial goals such as early retirement, find an advisor to help tailor your strategy.
Investors cannot invest directly in indices. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing. A diversified portfolio does not assure a profit or protect against loss in a declining market. The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly traded companies from most sectors in the global economy, the major exception being financial services. The S&P 500 is an index of 505 stocks chosen for market size, liquidity and industry grouping (among other factors) designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The Dow Jones Industrial Average is a price-weighted average of 30 U.S. blue-chip stocks traded on the New York Stock Exchange and NASDAQ. The index covers all industries except transportation, real estate and utilities. Options are not suitable for all investors. Investing in mutual funds is subject to risk and loss of principal. There is no assurance or certainty that any investment strategy will be successful in meeting its objectives.
Investors should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. The prospectus contains this and other information about the funds. Contact your financial advisor to obtain a prospectus, which should be read carefully before investing or sending money.
çExchange traded funds (ETFs) and mutual funds are sold only by prospectus. Investing in ETFs and mutual funds is subject to risk and potential loss of principal. ETFs incur trading and commission costs similar to stocks and frequent trading can negate the lower cost structure of an ETF. There is no assurance or certainty that any investment or strategy will be successful in meeting its objectives. Investors should consider the investment objectives, risks and charges, and expenses of the fund carefully before investing. The prospectus contains this and other important information about the fund. Contact your registered representative of the issuing company to obtain a prospectus, which should be read carefully before investing or sending money.
8253071.1-0825-C
