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."

Regular contributions to large index funds often form 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

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 or another large goal with a broad time horizon, index funds may be a great choice for your portfolio.

2. Do your research

When you type in an index fund's ticker, most brokers should show you a summary of the fund, including its performance history, objective and holdings.

When looking for funds to invest in, it's also important to consider several factors, such as:

• 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. Funds can be U.S.-based, traded on foreign exchanges or on a combination of international exchanges.

• Business sector or industry. Funds can be focused on different sectors, such as consumer goods, technology and health-related businesses.

• Asset type. Funds can track things other than stocks, such as bonds, commodities and cash.

• Market opportunities. Funds can also focus on emerging markets or other growing sectors for investment.

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

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.

Two funds may have the same investment goal — like tracking the S&P 500 — yet management costs can vary greatly. Those fractions of a percentage point may not seem like a big deal, but they can make a difference in your long-term returns. 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 deducted from your returns as a percentage of your 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.

» 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:

• Fund selection: Do you want to purchase index funds from various fund families? The big mutual fund companies carry some of their competitors’ funds, but the selection may be more limited than what’s available in a discount broker’s lineup.

• Convenience: You may want to find a single provider that can accommodate all your needs. For example, if you’re mainly focused on mutual funds, a mutual fund company may be able to serve as your investment hub. But if you want advanced stock research and screening tools, a discount broker that also sells the index funds you want may be better.

• Trading costs: Consider how much a broker or fund company charges to buy or sell the index fund. While many brokers offer no-transaction-fee mutual funds these days, it's something you'll want to double-check.

• 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.

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.

» Ready to get started? Brokers with no-fee, no-minimum index funds

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.

The best index funds

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

S&P 500 index funds

To arrive at our list, we looked for S&P 500 index funds with a Morningstar rating of at least 4 stars and chose the three with the lowest expense ratios. We excluded any funds not available to retail investors.

International index funds

We arrived at this list by filtering for international equity index funds with a Morningstar rating of at least 4 stars and chose the three with the lowest expense ratios. Funds not available to retail investors are excluded.

Bond index funds

To arrive at our list, we filtered for broad bond index funds with a Morningstar rating of at least 3 stars. We chose the three with the lowest expense ratios and excluded ones not available to retail investors.

Frequently asked questions