Index Funds Explained: A Low-Cost Way to Own a Slice of the Market

You don't need a big budget or a stock-picking hobby to invest, and index funds are one reason why.

If investing sounds like something for people with a lot of money and a lot of free time, index funds may change your mind. They're one of the simplest ways to own a small piece of many companies at once, often for a low cost.

That doesn't make them perfect or right for everyone. This guide covers what index funds are, how they work, why fees deserve your attention and what questions to ask before you buy.

What an index fund is

Start with two building blocks.

A market index is a list of investments that represents a part of the market. Think of it like a scoreboard. The S&P 500 and the Russell 2000 are examples. You can't buy an index directly, because it's just a measurement.

A fund pools money from many investors and uses it to buy a collection of investments. When you buy a share of the fund, you own a small slice of everything it holds.

Put them together and you get an index fund. The SEC's investor education site, Investor.gov, defines it as a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. In plain terms, the fund buys the investments in an index so its results look roughly like the index's results.

Passive vs. active: the key difference

Most funds fall into one of two styles.

Active funds have managers who pick investments they think will do better than the market. That takes research, frequent trading and often higher costs.

Passive funds, like index funds, don't try to beat the market. They aim to match an index. Investor.gov describes this as a passive strategy designed to achieve about the same return as a particular index, before fees.

Because index funds don't need a team hunting for winners, Investor.gov notes they typically involve:

• Less trading, which means fewer transaction costs.
• Lower realized capital gains, which can mean more favorable tax results. (A capital gain is profit from selling an investment for more than you paid.)
• Lower fees than actively managed funds.

Mutual fund or ETF?

Index funds come in two main forms.

• Index mutual funds are bought from and sold back to the fund at the next calculated net asset value (NAV), the per-share value of everything the fund owns, minus what it owes.
• Index ETFs (exchange-traded funds) trade on stock exchanges throughout the day. Investor.gov notes that ETF shares trade at market prices that may or may not match their NAV.

Investor.gov also says ETFs typically have fewer capital gains distributions, and thus lower taxes, than mutual funds. Either form can track the same kind of index. The better fit often depends on things like minimum investments, how you plan to buy and where you hold the account.

Why expense ratios matter so much

If there's one number to look up before buying any fund, it's the expense ratio.

Investor.gov defines the expense ratio as the percentage of a fund's average net assets used each year to pay the fund's operating expenses. These expenses can include management fees and other costs. You don't get a bill for it. Instead, it's taken out of the fund's assets, which quietly lowers your return.

A fraction of a percent can sound tiny. But fees compound over time, just like returns. Investor.gov's bulletin on fees gives a hypothetical example: $100,000 invested for 20 years with a 4% annual return would grow to about $208,000 with a 0.25% annual fee, about $198,000 with a 0.50% fee and about $179,000 with a 1% fee. That's a gap of roughly $29,000, just from fees.

That's why low costs matter so much when you're investing on a budget. Every dollar not spent on fees stays invested and keeps working for you.

One important caution from Investor.gov: not all index funds have lower costs than actively managed funds. Fees vary from fund to fund, so always check. You can find the expense ratio in the fee table of a fund's prospectus, the official document that describes the fund.

Risks and trade-offs to understand

Index funds are simple, but they still carry risk. Investor.gov highlights several points:

• Market risk. An index fund is subject to the same risks as the investments it holds. If the market falls, an index fund that tracks it falls too. You could lose money.
• No defensive moves. Because the fund follows its index, it generally can't sell holdings to avoid a downturn.
• Tracking error. An index fund may not perfectly track its index, especially if it holds only a sample of the index's investments. Fees and trading costs can also cause it to trail the index.
• How the index is built. Some indexes weight companies by their total market value, so the largest companies have the biggest influence. Others, like the Dow Jones Industrial Average, weight by share price. Knowing the method helps you understand what you actually own.

Also keep in mind that "index fund" covers a wide range. A fund tracking a broad stock market index is very different from one tracking a narrow industry. Investor.gov has separate guidance on newer, nontraditional index products, sometimes called "smart beta" funds, which use custom-built indexes to pick their investments.

How to get started on a small budget

You don't need much to begin. A few steps to consider:

1. Build a cushion first. Investing works best with money you won't need soon. Many people set aside savings for emergencies before investing.
2. Decide where to invest. Options include a workplace retirement plan, an IRA or a regular brokerage account. Each has different tax rules.
3. Compare a few funds. Look at what index each one tracks, its expense ratio, its minimum investment and whether it's a mutual fund or ETF.
4. Read the prospectus and shareholder reports. Investor.gov recommends reviewing these before investing.
5. Automate small amounts. Regular contributions, even small ones, can help you build the habit without trying to time the market.
6. Avoid checking every day. Index funds rise and fall with the market. Frequent checking can tempt you to react to short-term swings.

This article is for education only and is not financial advice. Everyone's situation is different.