The Best Index Funds and How to Start Investing

What are index funds?

An index fund is a group of stocks (or other investments) that aims to mirror the performance of an existing market index, such as the S&P 500. An index is made up of companies or securities that represent a part of the financial market. Some large indexes offer a look into the health of the economy as a whole.

Since these funds track an index, they are considered passively managed funds. Actively managed funds, like many mutual funds, have a manager who hand-picks investments in an attempt to beat the market.

How do index funds work?

Every time you buy a share of an index fund, the amount you invest is distributed across dozens, hundreds or even thousands of companies. This is known as "diversification."

Making regular contributions to large index funds often makes up the backbone of a long-term investment strategy. Exchange-traded funds (ETFs) can also achieve the same result and often have lower investment minimums.

To buy shares of index funds, you'll need a brokerage account (for more general investing) or an individual retirement account (IRA).

Pros and cons of index funds

How to invest in index funds

Investing in index funds is easy. Here's a quick rundown of how to do it.

1. Set a goal for your investments

Before you start investing in index funds, it's important to know what you want your money to do for you. Are you looking for a short-term place to park your money and earn a bit of interest? You may be more interested in certificates of deposit, savings accounts or money market funds.

If you're looking to let your money grow slowly over time, such as if you're saving for retirement, index funds may be a great choice for your portfolio.

2. Do your research

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:

• 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 and 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.

3. Pick your funds and examine costs

At this point, it's time to choose which index fund to buy. This often boils down to cost.

While low costs are one of the biggest selling points of index funds, don’t assume that all index mutual funds are cheap. They still carry administrative costs. These are subtracted from each 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 not seem like a big deal, but your long-term investment returns can take a hit from a small fee inflation. Typically, the bigger the fund, the lower the fees.

Here are the important areas to dig into:

• 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.

• 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. You can 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.

» Dive deeper: View our list of low-cost index funds

4. Decide where to buy them and place your order

You can purchase an index fund directly from a mutual fund company or a brokerage. When you're choosing where to buy an index fund, consider:

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.

» Need help? Here's how to open a brokerage account

5. Keep an eye on your investments

Index funds have become one of the most popular ways for Americans to invest because of their ease of use. But passive management doesn't mean you should 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 buying stocks.

» Ready to get started? Our picks of the best brokers for beginner investors

The best index funds

Index funds work by tracking specific market indices. So you'll need to know which market index you want your index fund to track before you start investing.

5 best index funds tracking the S&P 500

Here are some of the best index funds pegged to the S&P 500 based on expense ratios. The cheapest fund on our list is Fidelity Zero Large Cap Index (FNILX).

Top 3 index funds for the Nasdaq-100

Here are some of the best index funds pegged to the Nasdaq-100 index. The cheapest fund on our list is Invesco NASDAQ 100 ETF (QQQM).

Top 3 bond index funds

Here are some of the cheapest index funds that track the bond market. We compiled this list by looking at bond index funds with a Morningstar rating of at least 4 stars, and chose the three with the lowest expense ratios. The cheapest fund on our list is Fidelity US Bond Index Fund (FXNAX).

Frequently asked questions