Low-cost index funds: A beginner’s guide

Key takeaways

• Low-cost index mutual funds and exchange-traded funds (ETFs) are a great way to invest in the market, giving you a diversified fund with low expenses.

• Index funds are passive funds that track an established index, making changes only when the index itself changes, rather than actively trying to beat the market.

• Index funds are appropriate for all kinds of investors, but they can be especially valuable for less experienced investors.

A low-cost index fund can be a great way for both beginner and advanced investors to invest in the stock market. These funds generally are broadly diversified, thus reducing your risk compared with investing in individual stocks, and they’re a great choice if you want to minimize the time you spend investing, too. On top of that, index funds can offer attractive returns, in part by reducing the fees you pay.

With all these advantages, it’s little wonder that legendary investor Warren Buffett recommends index funds (notably a Standard & Poor’s 500 index fund) to most investors.

Here’s more information on how index funds work and a list of some of the cheapest index funds on the market.

How do index funds work

An index fund is an investment fund that tracks a specific collection of assets called an index. The index can include stocks, bonds and other assets, including commodities such as gold. The most well-known index is the Standard & Poor’s 500 index (S&P 500).

An index fund is a passive investment that tracks the assets included in the index. It aims to match the performance of the index by holding the same assets in the same proportions as the index.

An index fund can be bought and sold as either an exchange-traded fund (ETF) or a mutual fund. (Here’s the difference between ETFs and mutual funds.)

Learn more: Active investing vs. passive investing: What’s the difference

What are the major U.S. indexes?

Index funds can track any market index. Here are some of the most popular stock indexes.

• S&P 500: The S&P 500 index tracks around 500 of the largest companies in the U.S.

• Dow Jones Industrial Average: The Dow Jones Industrial Average is often referred to in the financial media and tracks 30 of the largest companies in the U.S.

• Nasdaq Composite: The Nasdaq Composite measures the performance of more than 3,000 companies listed on the Nasdaq stock market and is known for its heavy exposure to the technology sector.

• Nasdaq 100: The Nasdaq 100 index measures the performance of the 100 largest non-financial companies on the Nasdaq exchange, making it another tech-heavy index.

• Russell 2000: The Russell 2000 tracks the performance of around 2,000 of the smallest publicly traded companies in the U.S.

• Russell 3000: The Russell 3000 is a broad stock market index that tracks the performance of about 98% of the investable U.S. stock market.

What makes an index fund low-cost?

A fund management company charges investors for creating and managing the fund using what’s called an expense ratio. The expense ratio tells you what percent of your investment you’ll pay as a fee to the fund company. For example, a low-cost index fund might charge an expense ratio of 0.06%. That means you’d pay a fee of $6 annually for every $10,000 you invested in the fund.

Whether a fund is low cost is relative. Fund costs have been declining for decades, and today investors can easily find funds charging an expense ratio below 0.50%, or a cost of about $50 annually for every $10,000 invested. But the best index funds charge much less than that, often less than 0.10%, or about $10 annually for every $10,000 invested.

Another cost to watch out for is a sales load. The sales load is basically a commission to the salesperson, and it’s money that comes right out of your pocket. The good news is that it’s easy to avoid this cost, since many fund management companies offer no-load funds. And it’s a fee that applies only to mutual funds, so if you’re buying an ETF, you can rest easy here.

How to invest in low-cost index funds

1. Determine the type of fund you want

First, you’ll need to determine what your investing goals are.

• Are you investing for the highest-possible returns over a long timeframe and can ride out short-term volatility? Then you’ll want a stock index fund.

• Are you investing for more steady returns at the cost of a lower total return? Then you might want to consider a bond index fund.

For any stock investment, you should be able to leave your money invested at least three to five years without touching it in order to earn potentially higher returns. In the short term, stocks can be volatile, though they do well over time.

Learn more: 3 steps to set your investment goals

2. Research available index funds

Once you know the type of fund you want, you can start your research, looking for either stock index funds or bond index funds, or both. For your search, you can turn to free screeners such as those at Morningstar, which has separate screens for ETFs and mutual funds.

You can filter the funds by their expense ratio and then sort them by their returns, often over periods such as one year, three years, five years and 10 years. The lowest-cost funds charge less than 0.10% as an expense ratio.

You’ll also need to see if the fund is an index fund or an actively managed fund. Almost all ETFs are index funds, while a much smaller percentage of mutual funds are index funds. You’ll need to look further to determine if a mutual fund is an index fund, though it often says so in the fund’s name. Also, a stringent screen for low-cost funds likely eliminates most actively managed and non-index mutual funds anyway.

It can be valuable to stick to broadly diversified funds — ones that own many investments across industries — to reduce your overall portfolio risk.

3. Place your trade

Once you’ve determined the fund you want, you can place your trade. To do so, you’ll need to know the fund’s ticker symbol, a three-, four- or five-letter code, which you’ll input in your broker’s trading platform. You’ll also need to know how much the fund costs per share to determine how many shares you can buy with your available funds.

Once you’ve input the trade info, hit the buy button and you own shares in the fund.

What to consider when investing in low-cost index funds

The two most important things to know about investing in low-cost index funds are the index’s long-term returns and the cost to own the index fund. That is, you’ll want to earn the potentially largest return while paying as little as possible to the fund company to achieve that return.

Long-term returns

Investors looking for a top index fund should first check out what returns it could produce.

An index’s long-term performance is a good gauge to how it might perform in the future, but it is not a guarantee. Any fund will list its performance over a one- to 10-year period as well as from the fund’s inception. It will show you the annualized return over these periods, so you can get a sense of what you could earn in an average year.

Stock funds are likely to perform better long term than bond funds, but bonds may outperform stocks over shorter time periods. During periods of rising interest rates, bond prices will fall.

The S&P 500, for example, has returned about 10% annually over long periods of time.

The S&P 500 is a widely followed index, but many fund companies create their own proprietary indexes that are not as widely known. So you’ll want to check the long-term returns of the index fund over time to see how it could perform.

And when investing in funds don’t forget the importance of mean reversion. This technical investing term effectively means that a fund’s performance moves toward its long-term average. So, funds that have been outperforming their long-term average for the last year or two are more likely to revert to their long-term average than to sustain their above-trend performance. Mean reversion is one of many investing concepts; it’s not a guarantee of any future performance.

Cost

Imagine you had a choice of a Big Mac at two McDonald’s restaurants. Both serve the same hamburger, but one charges a higher price. You could literally buy the same thing but pay more for it at one location compared to the other.

It’s the same issue with index funds that are based on the same index. The key point for investors in index funds is to avoid unnecessary costs, and a few checks can help you do this.

• To check the cost of a fund, you can look it up with a quick search to see its expense ratio. The lower the expense ratio, the better, as that will result in higher returns on investments.

• To find funds with low expense ratios or no-load mutual funds, you can search for them at broker sites such as Fidelity Investments and Charles Schwab.

9 low-cost S&P 500 index funds

The S&P 500 is one of the most followed indexes in the world, and it has a number of index funds that track it. Like that McDonald’s hamburger, the returns of these funds are going to be about the same over time, so the key differentiator is each fund’s expense ratio.

Here are nine of the lowest-cost funds that track the S&P 500:

It’s worth noting that many other funds are “closet trackers,” meaning they don’t technically track an index but do so in practice due to what they own. Many such funds also charge much more than the low-cost funds mentioned above and may not deliver the same high performance.

Low-cost index funds: ETFs vs. mutual funds

You can buy low-cost index funds as either an ETF or a mutual fund, and well-known indexes such as the S&P 500 will have both available. The list above, for example, contains both kinds. (The three-letter ticker symbols are for ETFs, while the five-letter symbols are for mutual funds.)

In many cases, what determines the kind of fund you can buy is the platform you’re using. That is, some platforms such as 401(k) retirement plans will allow you to purchase only mutual funds. Similarly, while ETFs are generally available at all brokers that allow stock trading, you may not be able to buy all mutual funds, depending on the broker’s relationship with the fund company. For example, most brokers don’t carry Fidelity’s no-fee fund, so you’ll have to go to Fidelity to get it.

Given the ability to choose any S&P 500 fund, there’s little reason to prefer an ETF over a mutual fund or vice versa. Ultimately, what you’re looking for is the lowest-cost fund that delivers the same overall investing performance.

Bottom line

The key difference among index funds that track the same index is basically just the cost. That’s why experts tell investors to focus on expense ratios when looking at funds based on well-known indexes such as the S&P 500. A fee that doesn’t go into the fund manager’s pocket is money that can compound for you for years.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.