Low-Cost Index Funds: Definition, How to Invest

• Index funds are passively managed investment vehicles that track an underlying market index.
• A key differentiator between index funds and other types of funds is their cost.
• Even a small difference in a fund’s expense ratio can have a big impact on long-term returns.
• Read more stories from Personal Finance Insider.

An

index fund

is an investment vehicle designed to match the returns of a market index such as the S&P 500 by owning the same assets in the same proportions as the underlying gauge. Since most S&P 500 index funds will look pretty much the same under the hood, a key consideration in picking one is cost. Lower-cost funds mean less of your money is going toward covering fund expenses.

How do index funds work? 

Since index funds are designed to track an underlying index, the funds’ managers aren’t actively deciding what to buy and sell. Instead, they just follow the benchmark’s lead. They can be mutual funds or exchange-traded funds (ETFs), which are most common. Actively managed funds may use an index as a benchmark but the managers can deviate from the index’s structure.

“Index funds can serve as an entry point to the market for new investors, act as building blocks in portfolio construction, and offer a clear understanding of the investment objective,” says Scott O’Reilly, head of index, sector, international, and factor products at Fidelity Investments.

Being passively managed, index funds typically have lower turnover and fewer

capital gains

distributions, O’Reilly says. Turnover is the amount of buying and selling a fund does. Indexes only need to trade when their benchmark does — usually only two to four times a year for most indexes.

An index fund can also hold hundreds or even thousands of securities, making it an easy avenue for diversification. Remember, though, that diversification is about more than just the number of securities you own. The Russell 2000 may seem diversified with 2,000 companies, but if you own only those, you’re still entirely invested in small US companies. To be truly diversified, you need to own a broad range of securities of differing sizes and types.

Index funds are also vulnerable to market swings. If the benchmark declines, your index fund will, too. In an actively managed fund, the manager may be able to mitigate some of this downside, but passively managed funds are beholden to the index.

How index funds can help lower your cost of investing 

Index funds have become increasingly popular investment vehicles. Consider that just two of the biggest, Vanguard’s S&P 500 ETF (known by its ticker, VOO) and the SPDR S&P 500 ETF Trust, themselves have a combined market value of more than $1.2 trillion. The growth behind funds such as these is largely driven by their relatively low cost structure.

The biggest measure of cost with funds is the expense ratio. This represents the percentage of fund assets that are used to cover operating costs. If a fund has a 1%

expense ratio

, this means 1% of the money you put in will go toward the fund’s expenses rather than generating a return on your investment. 

Even small differences in a fund’s expense ratio can have a large impact on your long-term return. The Securities Exchange Commission (SEC) gives an example of a $20,000 investment in a portfolio with a 4% average annual return. After 20 years at a 1% annual fee, that portfolio is worth $30,000 less one with the same returns but only a 0.25% annual fee.

Passive management is what enables funds to keep their expenses low. Since index fund managers are not actively selecting securities for the fund, their workload is lighter and therefore costs less. They’re able to pass on those savings to investors.

The average expense ratio on an index fund is under 0.5%, but some go as low as 0%. SPY has an expense ratio of 0.095%, and VOO’s is 0.03% By comparison, the average expense ratio on actively managed funds is around 0.6%, according to data compiled by Morningstar, but can be upward of 1.5%.

Another cost to look out for when investing in mutual funds is the sales load. A sales load is a fee paid to an intermediary for selling the fund to you, much like a commission. Sales loads can be front-end, meaning the fee is taken when you buy the fund, or back-end, meaning the fee is taken when you sell.

Sales loads only apply to mutual funds, not ETFs, and not all mutual funds have them. Sometimes your brokerage firm will waive the sales load for you, too.

How to invest in index funds 

Index funds are also popular because of how easy it is to invest in them. All you need to do is determine what index you want to track, find a fund that does it, and place an order.

1. Select an index you want to track

Selecting an index to track is probably the hardest part of investing in index funds. There are more than three million market indexes around the world, according to the Index Industry Association. 

Indexes can be based on market value, such as large capitalization companies like the S&P 500 or small-cap stocks like the Russell 2000. They can focus on specific industries or sectors of the market, like the Philadelphia Semiconductor Sector Index. Other indexes are distinguished by asset type, such as stock indexes or bond indexes. There are indexes that focus on a particular region like the MSCI Emerging Market Latin America index. And this is only the beginning. Indexes can be built to track just about anything, which is why it’s so important to choose the right one.

“The benchmark that an index fund seeks to track is really going to drive the risk/return profile of the fund,” O’Reilly says. “So investors should really understand the market exposure that the underlying index provides.”

2. Choose a fund that tracks the index

“When choosing between funds that follow the same index, investors should look for the lowest-expense option that most closely tracks the benchmark,” O’Reilly says. “Generally, the expenses are going to be a big determinant of how closely the fund’s performance tracks to the benchmark.”

Since expenses are deducted from your returns, a fund with a lower expense ratio will more closely track the return of the benchmark index.

You can find a fund’s expense ratio on the quote page of investment research providers. You can also look for tracking error, which measures how closely the fund tracked its benchmark during a given period. Both SPY and VOO have tracking errors of 0.01, but VOO’s lower expense ratio might give it an edge.

Index mutual funds may have investment minimums, as well, such as $1,000 or $3,000 for your first purchase. The only minimum on an ETF is its share price.

It’s also worth considering the total cost of your relationship with the fund provider. “If the investor will likely want additional services, the investor should consider whether those services will be priced fairly,” says a Vanguard spokesperson. “Some firms will offer a low cost on one product with the goal of making it up by charging higher fees for other products and services.”

3. Buy shares in the fund you selected

Once you’ve chosen the fund you’d like to purchase, all that’s left is to place an order. If you’re buying an index ETF, you’ll need to choose how many shares of the fund you’d like to purchase. You then have to decide what type of order you’re placing: a market order or limit order.

A market order means your trade will be placed at the next available price. With a limit order you can set a maximum price at which you’re willing to buy. Your purchase won’t be made unless the ETF trades at or below your limit price. For most beginning investors, a market order is the best choice. With limit orders, your trade may never go through, leaving you out of the market for an indefinite amount of time while you wait for the price to drop.

With mutual funds, you can choose to buy a number of shares or a specific dollar amount. Mutual funds do not trade throughout the day the way ETFs do. Instead, your trade is processed by the fund manager directly at the end of the trading day. This means that you won’t know the price of the shares until after the market closes, so make sure you have a little wiggle room in your cash available to trade when buying per share.

Pros and cons of index funds 

While index funds can be great investment vehicles, as with every investment, they have their drawbacks. It’s important to weigh the pros and cons before investing.

It could be said that index funds are democratizing investing by making it easier for everyone to participate in the stock market. If you don’t know where to start investing, consider an index fund for low-cost simplicity.