Index funds and ETFs explained: a beginner's guide to low-cost investing

An index fund does not try to find the next winning stock. It buys a whole market, or a defined slice of one, and charges you relatively little to do it. That idea sits at the core of most long-term portfolios. Here is how these funds work, how an index mutual fund differs from an ETF, and what to check before you buy.

What an index is

An index is a list of securities picked by a fixed rule to represent a market or part of one. The S&P 500 tracks large US companies, the Russell 2000 tracks smaller US companies, and the Wilshire 5000 Total Market Index aims to cover the whole US stock market. Bond markets have indexes too.

You cannot buy an index itself. An index fund holds every security in it, or a representative sample, so that its return follows the index.

Most stock indexes are weighted by market value (share price times the number of shares), so the largest companies move the index the most. A few, such as the Dow Jones Industrial Average, are weighted by share price instead.

Because an index fund trades rarely and does not pay analysts to pick stocks, it can usually charge less than an actively managed fund, though the SEC points out that not every index fund is cheap. Index funds also carry the risks of whatever they hold, and they can lag their index slightly because of fees, trading costs and "tracking error", meaning small gaps between the fund's holdings and the index.

Index mutual fund or index ETF?

The same index can be packaged as a mutual fund or as an exchange-traded fund (ETF). Both pool money from many investors and are registered with the SEC. The main differences are in how you buy, sell and pay.

The bid-ask spread is the gap between what buyers will pay and what sellers want. The SEC's own example: with a bid of $59.50 and an ask of $60.00, buying 200 shares and selling them straight away costs $100. Heavily traded ETFs tend to have tighter spreads.

On taxes, the ETF advantage only matters in a regular brokerage account. Inside a 401(k) or IRA, fund distributions are not taxed when they are paid, so a low-cost index mutual fund and a low-cost index ETF are close substitutes there.

In practice, a mutual fund often makes automatic monthly investing of exact dollar amounts easier, while an ETF suits buying in a brokerage account whenever you choose. Either is fine if the index is right and the fee is low.

The expense ratio: the fee you never see

The expense ratio is a fund's yearly operating cost as a percentage of its assets. You never get a bill. It is taken out of the fund's assets, so it shows up only as a lower return. You will find it in the prospectus fee table under "annual fund operating expenses" and on the fund's website.

At 0.05%, you pay about $5 a year for every $10,000 invested. At 0.75%, it is $75. That looks trivial, but it repeats every year on a growing balance. The SEC illustrates this with $100,000 invested for 20 years at 4%: with a 0.25% annual fee it grows to about $208,000, with a 1.00% fee to about $179,000.

Watch for other charges too. FINRA notes that front-end sales loads typically run from 2% to 5% of the amount you invest, and 12b-1 marketing fees can be up to 1% of assets a year. Many broad index funds charge neither, so check before you accept them.

Worked example: 0.05% vs 0.75% over 30 years

Assumptions for illustration only: $500 invested at the end of every month for 30 years, a steady 7% gross annual return compounded monthly, and the expense ratio subtracted from that return. No taxes or trading costs. Real returns change from year to year and can be negative.

Same savings, same market, and the higher-fee fund ends $77,042 behind, about 13% less money (with no fee at all, the balance would be $609,985). The cost is bigger than the fees themselves because every dollar taken in fees also loses the growth it would have earned. You can rerun this in our compound growth calculator with returns of 6.95% and 6.25%.

Four building blocks

Most beginner portfolios are built from a few broad index funds:

• Total US stock market. Large, mid-size and small US companies in one fund.
• S&P 500. Large US companies only. Because large companies dominate a market-value-weighted index, an S&P 500 fund and a total-market fund move very similarly. Holding both adds little diversification.
• International stocks. Companies outside the US, in developed and often emerging markets. This covers companies, economies and currencies a US fund does not hold.
• Bonds. A total bond market or government bond index fund. Lower expected returns than stocks, but usually much smaller swings, which steadies the whole portfolio.

How much to put in each is a separate decision. Our asset allocation guide covers that, including target-date funds that hold all of these for you.

How to read a fund fact sheet

A fact sheet is the short summary a fund publishes on its website. The prospectus is the full legal document. Check these items, in this order:

1. The index. The fact sheet names the exact index the fund tracks. Make sure it is the market you want (US total market, not a narrow sector, for example). Funds generally must put at least 80% of their assets into the type of investment their name suggests, but the index name tells you far more.
2. Expense ratio. Compare it with other funds tracking a similar index. If a "net" ratio relies on a temporary fee waiver, check when it ends.
3. Loads and 12b-1 fees. Ideally none.
4. Holdings. The number of holdings and the share in the top 10 tell you how concentrated the fund is.
5. Tracking. Compare the fund's returns with the index's returns over the same periods. A gap close to the expense ratio is normal; a consistently bigger gap is a warning sign.
6. For ETFs: premium, discount and spread. ETF websites publish the NAV, closing price, historical premiums and discounts, and median bid-ask spread.

Past returns on the fact sheet tell you what the index did, not what it will do.

What to do this week

1. List every fund you own, in your 401(k), IRA and any brokerage account, with its expense ratio from the fact sheet. FINRA's free Fund Analyzer can compare the costs of up to three funds side by side.
2. Flag any fund with a sales load, a 12b-1 fee, or a much higher expense ratio than a broad index fund covering the same market, and check whether your plan or broker offers a cheaper option.
3. If you have not started yet, read how to start investing for the order to fund your accounts in.

General education, not personal financial advice. Figures are illustrations computed from the stated assumptions.