This lesson is general education about U.S. personal finance, not financial, tax or investment advice. Tax rules and limits change every year; check IRS.gov or a qualified professional for your situation.
What you’ll learn
- An index fund holds the investments in a market index, such as a broad index of large U.S. companies.
- Low costs are one of the main advantages, and small fee differences add up over decades.
- Index funds come as mutual funds and as exchange-traded funds (ETFs).
- They still go up and down with the market, and they aren’t insured against losses.
A market index is a list of investments that represents part of the market, along with rules for how much of each it holds. An index fund buys what’s in the index, so its returns track the index’s returns, minus costs.
Index funds versus actively managed funds
An actively managed fund pays a manager and analysts to pick investments they hope will do better than the market. An index fund simply follows its index. Because there’s less research and trading, index funds usually charge less.
Active managers sometimes beat their benchmark, but it’s hard to know in advance which ones will, and their higher fees have to be earned back first.
Why costs matter
Every fund charges an annual fee called the expense ratio, taken from the fund’s assets.
Try the math. On a $10,000 investment, an expense ratio of 0.05% costs about $5 a year. An expense ratio of 1% costs about $100 a year. Over decades, and on a growing balance, that gap becomes thousands of dollars, because money paid in fees stops compounding for you.
The SEC’s Investor.gov site has free calculators that show how fees affect a balance over time.
Mutual fund or ETF?
| Index mutual fund | Index ETF | |
|---|---|---|
| How it trades | Once a day, at the day’s closing price | During the day, like a stock |
| Minimum investment | Sometimes set by the fund | Often the price of one share |
| Where you’ll find it | Retirement plans, brokerages, fund companies | Brokerage accounts |
Many 401(k) plans offer index mutual funds; brokerage accounts and IRAs can hold either.
Risks that remain
- Market risk: when the market falls, an index fund falls with it.
- What the index holds: a fund tracking one sector or country is less diversified than a broad market fund.
- No guarantees: investment accounts aren’t bank deposits and aren’t FDIC-insured.
Before opening an account, it’s worth knowing how to check a broker or adviser.
Common questions
Is an index fund safe?
It spreads your money across many companies, which reduces the risk of any one of them failing. It doesn’t protect you from the whole market falling, and it isn’t FDIC-insured.
How much do I need to start?
Many ETFs can be bought for the price of one share, and some brokers let you buy fractions of a share. Some mutual funds have minimum initial investments.
Are all index funds the same?
No. They track different indexes, from broad U.S. or global stock markets to bonds or narrow sectors, and their costs differ. Read the fund’s description and fees.