Investing in Index Funds: What You Need to Know

They’re easy to invest in, have low fees, and often perform very well

Reviewed by Julius Mansa
Fact checked by Suzanne Kvilhaug

Warren Buffett is one of the most successful investors of all time. His investing style, which is based on discipline, value, and patience, has yielded results that have consistently outperformed the market for decades.

While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.

As Buffett wrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.

Key Takeaways

• Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
• Over the long term, index funds have generally outperformed other types of mutual funds.
• Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they’re highly diversified).

What Is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible.

The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity.

When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification.

By investing in several index funds tracking different indexes, you can build a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.

You can start investing in index funds with one of the best online brokers and trading platforms, such as the ones below:

What Are the Benefits of Index Funds?

The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.

One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.

Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

What’s more, by trading in and out of securities less frequently than actively managed funds do, index funds generate less taxable income that must be passed along to their shareholders.

Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.

Important

If you’re shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.

What Are the Drawbacks of Index Funds?

No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index.

If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.

It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio but even outperform the market. However, few managers have been able to do that consistently, year after year.

Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.

Pros

• Very low fees

• Lower tax exposure

• Passive management tends to outperform over time

• Broad diversification

Cons

• No downside protection

• Doesn’t take advantage of opportunities

• Cannot trim under-performers

• Lack of professional portfolio management

What Is an Index Fund?

An index fund is an investment fund whose strategy is to mirror a market index. The investment fund buys the securities that the index tracks in order to replicate the results. For example, an investment fund that tracks the S&P 500 would purchase the stocks of the approximately 500 companies in the S&P 500 index.

Index funds don’t seek to beat the market, only to replicate the returns of their benchmarks. As such, index funds are known as passive investments as opposed to active investments; the latter of which seek to outperform the market. Because of this passive investment style, index funds have lower fees than actively managed funds.

What Is the Largest ETF Index Fund?

The largest ETF index fund is the SPDR S&P 500 ETF, which tracks the S&P 500. The fund started trading in January 1993 and has a low expense ratio of 0.0945%.

How Do You Invest in an Index Fund?

To invest in an index fund, open a brokerage account, for example at E*Trade, Fidelity, or Charles Schwab. Next, deposit money in your account. Then you can select which index fund to buy. Purchasing a popular exchange-traded fund (ETF) is a good way to get started. After placing the order, you have invested in an index fund. As with all investments, it’s important to monitor the performance of your index fund and your investment in it.

The Bottom Line

Index funds have several attractive pros but also some cons to consider. The funds are passive investments that track major indexes making them a low-cost investment option.

These funds are nearly as automatic and hands-off as using a robo-advisor which is another option for those looking for low-cost investing. Understanding what an index fund is and how it compares to other investments is the best first step you can take.