But what is an index fund, exactly, and how do you invest in one?
It may sound pretty complicated, but it’s not. Read on and we’ll break it down for you.
What is an index fund?
Index funds are a type of mutual fund, which means they are pools of money collected from many investors at once, hence the word “mutual”.
They were popularized in the 1970s by the late mutual fund legend John Bogle, founder of the Vanguard Group. Before this, old-school mutual funds were handled by a professional money manager who picked a variety of stocks to invest in at once—and charged investors a pretty penny to do so.
Index funds, on the other hand, automatically invest in a specific group or “index” of stocks that are lumped together based on things like industry, company size, or geographical location. They can be a low-cost, hands-off way to participate in the stock market without having to pick individual stocks or pay a mutual fund manager to pick a basket of stocks for you.
For instance, many popular U.S. index funds follow the Standard & Poor’s 500 (S&P) or the Dow Jones Industrial Average (DJIA) indices. The performance of the index fund attempts to track the performance of the overall index itself, generally rising and falling along with the group.
Investing in an index fund can help you diversify—meaning that if one stock in the group falls, the investor could be protected by the presence of the other stocks in the group. And because such funds are not actively managed, they may have lower fees than traditional mutual funds, making them attractive for cost-conscious investors who are investing for the long term. One of the disadvantages of index mutual funds, however, is that, like all mutual funds, they are less “liquid” than individual stocks, because they only trade once a day, at the market close. Individual stocks, on the other hand, can be bought and sold virtually instantaneously, whenever the stock market is open.
ETF Index Funds
The creation of exchange-traded funds (ETFs) has simplified trading of index funds. ETFs are similar to index mutual funds in that they often correspond to an index or an industry sector—you can choose to invest broadly in technology or health care or energy, for instance, or just about anything else. But like stocks, ETFs can be bought and sold throughout the day and are not simply priced at the market close like traditional index mutual funds.
Now that you know what an index fund is, and their two basic kinds—index mutual funds and index ETFs—let’s get to the fun stuff: How to buy them!
The nuts and bolts: How can I invest in index funds?
Index funds are widely available through online and brick-and-mortar brokerages. Some brokerages specialize in index mutual funds, and some, like Stash Invest, specialize in ETFs, including index ETFs.
When you’re deciding which brokerage to use, it’s important to consider the selection of funds available to you—there are more than 10,000 ETFs and mutual funds out there—and the costs involved.
For instance, there are commission-free and no transaction fee choices available that can help save you money when you start investing. Also, consider how much the brokerage charges to buy or sell funds generally. Keep in mind that mutual fund fees may be higher than ETF fees.
Once you’ve picked a brokerage and opened an account (find out more about how to do that here), the next thing to do is pick an index. Many funds track the performance of the major U.S. indexes. The S&P 500 index is one of the most popular ones to invest in, because the 500 companies it tracks include large, well-known U.S. businesses across a variety of industries. It is considered a gauge of the larger U.S. economy, and it’s often a benchmark against which other indexes are measured.
But the S&P 500 certainly isn’t the only game in town. There are indexes—and corresponding funds—based on all kinds of things. Here are a few major ones to consider:
- Company size. Some index funds are designed to track indexes that focus on small, medium-sized, or large companies. The Dow Jones Industrial Average index, for instance, consists of 30 of the largest American companies, while the Russell 2000 index features 2,000 of the best small-cap companies in the U.S. Indexes might track either of those, and their corresponding companies.
- Business sector. These funds focus on a specific kind of industry, making them an attractive choice for people who want to invest in a specific business area that they expect to grow in the future. Some funds, for instance, may focus on the legal marijuana industry. Others might invest in companies in the cybersecurity industry, an area that is seemingly in the news every day lately, as companies and governments across the world try to gird themselves against malicious hackers.
- Geography. The United States remains the world’s No. 1 economy, but there are many attractive investment opportunities elsewhere as well. Some indexes might invest in Europe or Asia, allowing U.S. investors get in on the action overseas.
- Asset type. You don’t need to limit yourself to stocks either. There are also funds that track domestic and foreign bonds, commodities, and currencies.
- Missions and causes. Investors can also put their money into causes they’re passionate about, whether for ethical or personal reasons. For example, you can invest in companies that are active in the fight against climate change, or companies that focus on gender equality by putting women in the executive suite, among other possibilities.
Anything else I should consider?
Generally speaking, index funds are relatively low-cost, thanks to the high degree of automation involved. However, you shouldn’t assume that all index funds are cheap. As with any investment, it’s important to do your research before you buy. Look for things like expense ratio and tax-cost ratio.
Also, many brokerages have an account minimum, and mutual funds in particular often have an investment minimum—both of which can be thousands of dollars.
But if you’re a new investor without a lot of capital, don’t worry, there are also plenty of low-fee or no-fee options out there.
Stash lets you get started investing for just $5.