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How to Invest in Index Funds

Index funds are a low-fee, no-fuss way to invest money. It might be the smartest and easiest investment you ever make.
Aug. 17, 2018
Investing, Investments
How to Invest in Index Funds
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Everyone gushes about index mutual funds, and for good reason: They’re an easy, hands-off, diversified, low-cost way to invest in the stock market.

When investors buy an index fund, they get a well-rounded selection of many stocks in one package without having to purchase each individually. And because these funds simply hold all the investments in a given index — versus an actively managed fund that pays a professional to do the stock picking — management fees tend to be low. The result: Higher investment returns for individual investors.

Lastly, index funds are easy to buy. Here’s how it’s done.

Buying an index fund in 3 steps

  1. Decide where to buy. Look at a broker’s fund selection, commission-free options and trading costs.
  2. Pick an index. Funds may track well-known indexes like the S&P 500 or specific industries or types of companies.
  3. Check investment minimum and other costs. Find the right fund for your budget.

Step 1. Decide where to buy

You can purchase an index fund directly from a mutual fund company or a brokerage. Same goes for exchange-traded funds (ETFs), which are like mini mutual funds that trade like stocks throughout the day (more on these below).

» Want to cut to the chase? See our picks for best brokers for mutual funds and best brokers for ETFs.

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. 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.)
  • Commission-free options. Do they offer no-transaction-fee mutual funds or commission-free ETFs? This is an important criterion we use to rate discount brokers. (The selections at Charles Schwab, E-Trade, Fidelity and TD Ameritrade are worth checking out.)
  • 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, compared with less than $10 a trade for stocks and ETFs.

» Want help building your investment plan? Check out our top picks for robo-advisors.

Step 2. Pick an index

Index mutual funds track various indexes. The Standard & Poor’s 500 index is one of the best-known indexes because the 500 companies it tracks include large, well-known U.S.-based businesses representing a wide range of industries.

But the S&P 500 isn’t the only index in town. There are indexes — and corresponding index funds — composed of stocks or other assets that are chosen based on:

  • Company size and capitalization. Index funds that track small, medium-sized or large companies  (also known as small-, mid- or large-cap indexes).
  • Geography. These funds focus on stocks that trade on foreign exchanges or a combination of international exchanges.
  • Business sector or industry.  Funds that focus on consumer goods, technology, health-related businesses, for example.
  • Asset type. Funds that track domestic and foreign bonds, commodities, cash.
  • Market opportunities. Emerging markets or other nascent but growing sectors for investment.

Despite the array of choices, you may need to invest in only one. His Royal Investment Highness Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. (For more, check out our story on simple portfolios to get you to your retirement goals.)

» Looking for other ways to invest? Here’s our guide to investing in stocks.

However, you can easily customize your allocation if you want additional exposure to specific markets in their portfolio (such as more emerging market exposure, or a higher allocation to small companies or bonds).

Step 3. Check investment minimum, other costs

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.

Even though they’re not actively managed by a team of well-paid analysts, they 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.

The main costs to consider:

  • Investment minimum. The minimum required to invest in a mutual fund can run as high as a few thousand dollars. Once you’ve crossed that threshold, most funds allow investors to add money in smaller increments.
  • 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 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 call up a quote of a mutual fund on a financial site. For context, the average annual expense ratio was 0.09% for stock index funds and 0.07% for bond index funds, versus 0.82% for actively managed stock funds and 0.58% for actively managed bond funds, according a 2016 report from the Investment Company Institute.
  • Tax-cost ratio. In addition to paying fees, owning the fund may trigger capital gains taxes if held outside tax-advantaged accounts like a 401(k) or an IRA. Like the expense ratio, these taxes can take a bite out of investment returns: typically 0.3% of returns when invested in an index fund, according to a 2014 study by Vanguard founder John Bogle. Fund tracker Morningstar calculates the tax-cost ratio, which shows the percentage by which a fund’s performance has been reduced by taxes.

Below are three strong options from our analysis of the best brokers for fund investors: E-Trade (a top overall pick), TD Ameritrade (good for its fund selection) and Ally Invest (a nice choice for cost-conscious investors):

Trade Fee

$6.95

$6.95

Account Minimum

$500

$500

Promotion

60

60

days of commission-free trades with a qualifying deposit

Trade Fee

$6.95

$6.95

Account Minimum

$0

$0

Promotion

500

500

commission-free trades + up to $600 with qualifying deposit

Trade Fee

$4.95

$4.95

Account Minimum

$0

$0

Promotion

$50

$50

in cash bonus with a qualifying deposit

For more funds-specific information and choices, read our roundup of the best brokers for mutual funds.

Other things to keep in mind

Index funds have become one of the most popular ways for Americans to invest because of their ease of use, instant diversity and returns that typically beat actively managed accounts. Some additional things to consider:

  • 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? Invest in an exchange-traded fund that tracks the index. Instead of having to buy the main-course mutual fund, you purchase just a slice of the fund. (Here are some pros and cons of investing in ETFs versus mutual funds.)
  • Want to buy stocks instead? Learn how to trade stocks with these step-by-step instructions
  • New to investing? This guide to the best online stock brokers for beginning investors will help.
  • How much will you need to retire? Use our retirement calculator to track your progress.

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