What Is an Index Fund?

Investing can seem intimidating: What if you make a bad choice and lose money? or what about a lack of access to quality investing advice? At the end of the day, however, that fear can be holding you back from really growing your net worth.

The good news is there are many easy ways to invest; you don’t have to worry about picking individual stocks, and hiring an expensive advisor isn’t always necessary.

One of the easiest ways to get started investing is through index funds.

Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100.

When you put money into an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.

Let’s use the S&P 500 as an example. The S&P 500 is one of the major indexes that tracks the performance of the 500 largest companies in the U.S. Investing in an S&P 500 fund (one of the most popular) means your investments are tied to the performance of a wide range of companies.

Because the goal of index funds is to mirror the same holdings of whatever index they track, they are naturally diversified and thus hold a lower risk than individual stock holdings. Market indexes tend to have a good track record, too. Though the S&P 500 certainly fluctuates, it has historically generated nearly a 10% average annual return over time for investors. (Just remember that future returns are not guaranteed.)

Index investors don’t need to actively manage their investments as closely since the fund is just copying a particular index. This is why index funds are known as passive investing — and it’s what sets them apart from actively managed mutual funds.

Actively manage mutual funds are operated by fund managers who choose your investments. The goal with these funds is to beat the market, while the goal with index funds is simply to match the market’s performance. Since index funds don’t require daily human management, they have lower management costs (called “expense ratios”) than mutual funds. The money saved in fees by investing in an index fund over a mutual fund can save you lots of money in the long term and in turn help you make more money.

A common strategy for many investors who have a long investment timeline is to regularly invest money into an S&P 500 index fund (known as dollar-cost averaging) and watch their money grow over time.

Some of the top index funds are those that track the S&P 500 and have low costs. For example, Charles Schwab offers a S&P 500 index fund as a straightforward option with no investment minimum. Its expense ratio is 0.02%, meaning every $10,000 invested costs $2 annually. Passive, or index funds, generally have a 0.12% expense ratio, so this is notably low.

For an option with no expense ratio whatsoever, consider Fidelity’s fund that tracks large capitalization stocks.

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