How to invest in index funds (2024)

Have you heard the term “index funds” but don’t know what they are or whether they’re worth including in your portfolio?

For most investors looking for a cost-effective, easy way to track market returns, index funds are absolutely worth considering.

However, it’s important to understand the benefits and risks of index funds before incorporating them into your investing strategy.

What are index funds?

Index funds are pooled investments designed to mirror the performance of a particular market index, such as or the Dow Jones Industrial Average.

Over the past few decades, they’ve become increasingly popular and surpassed actively managed funds in terms of dollars invested.

Besides tracking the biggest indexes in the United States, index funds also give investors exposure to other assets, including international stocks, bonds and even commodities.

“Broad-based, low-cost index funds are a great, simple way to build a globally diverse portfolio,” said Chris Urban, a certified financial planner (CFP) and founder of Discovery Wealth Planning in McLean, Virginia.

“You can get all of the exposure you need with just a handful of exchange-traded funds or mutual funds that invest in stocks, bonds, real estate, hard assets like gold or silver, and alternatives,” Urban said.

How do index funds work?

Index funds pool money from a large number of investors to buy a basket of securities that mirrors an index’s composition.

Let’s use the largest index exchange-traded fund (ETF) as an example. The SPDR S&P 500 ETF Trust (SPY), which launched in 1993, has $509 billion in assets as of March 18, 2024.

Because the S&P 500 is weighted according to market capitalization, the biggest stocks in the index are also the largest holdings in the ETF.

By the same token, the smallest S&P 500 companies, in terms of market cap, carry the lowest weightings within an S&P index fund.

As a company’s market capitalization becomes either larger or smaller, its weighting within the S&P 500, or any other market-cap weighted equity index, will change. For many years, the largest stock in the S&P 500 was Exxon Mobil (XOM) until it was eclipsed by, among others, fast-growing technology companies that have dominated the index in recent years.

Benefits of investing in index funds

Index funds became popular because they have several inherent benefits:

• Low costs: Because these funds simply track an index, they use what’s called a passive investment approach, meaning there’s no manager actively picking stocks.
• Ease of use: For investors who don’t have the time to research individual stocks, or aren’t interested, index funds offer an easy way to access broad market exposure.
• Steady returns: Index funds historically offer steady and reliable long-term returns, as their diversified holdings minimize risks associated with single stocks.

“Overall, index funds provide a straightforward and cost-effective way for investors to gain exposure to the broad market, offering diversification, consistent performance and long-term growth potential,” said Adam Puff, president and founder at Haddonfield Financial Planning in Haddonfield, New Jersey.

Versatility is another advantage.

“Index funds have grown to the point where you can find one to match almost any investment class or sector you may want to target,” Puff added.

Risks of investing in index funds

Although index fund investing can mitigate the risk of single stocks, it’s important to remember that all investments carry risks.

“Economic downturns or sector-specific challenges can affect the performance of the underlying index and, consequently, the fund’s returns,” said Cliff Ambrose, founder and financial advisor at Apex Wealth in Danvers, Massachusetts.

He also said that because index funds passively track an index’s performance, investors miss out on the potential for outsized gains that active management might achieve during bull markets.

“Nonetheless, for long-term investors focused on consistent, steady growth, these risks are often deemed acceptable trade-offs,” Ambrose said.

Step-by-step guide to investing in an index fund

The process of how to invest in index funds takes just a few easy steps.

1. Do your homework: Research index funds to identify those that align with your investment goals, risk tolerance and time horizon. Consider factors such as the underlying indexes the funds are tracking, the funds’ expense ratios and how your portfolio as a whole is allocated.
2. Open an account: Now it’s time to open an investment account at a brokerage. This step involves completing some online forms and generally only takes a few minutes. If you’re looking to invest in a fund to track a commonly held index like the S&P 500, you shouldn’t have any problem finding a brokerage that offers access.
3. Fund your account: This is where you begin to consider how much to invest in index funds. You can deposit funds into your investment account from your bank account, usually via an electronic transfer, but you can also fund an account with a check. Some index funds have minimum investment requirements, so be sure you deposit enough to meet those minimums.
4. Place your order: It’s time to click that “buy” button! Use your investment account to purchase shares of your chosen index fund. You can do this through the brokerage’s online platform by entering the amount you want to invest, either in terms of shares or a dollar value.
5. Monitor and rebalance: The old days of putting a portfolio on “ignore” are long gone. The best practice for index fund investors is to review portfolio performance regularly and rebalance by buying or selling shares of index funds as needed to maintain pre-determined allocations.

Deciding where to buy your index funds

When deciding where to buy your index funds, you’ll face two choices.

First, you’ll have to choose a brokerage. Charles Schwab, Fidelity and Vanguard are some of the biggest brokerages where a do-it-yourself investor can open an account.

Also, companies like Betterment offer fully automated index-fund investing through ETFs. Those companies, known as robo-advisors, only use index funds, with the allocations determined by factors such as an investor’s time horizon and risk tolerance. The larger brokerages also offer robo-advisor options that may invest in index or active funds.

The second choice involves what kind of account to use for index funds. You can hold an index fund in either a taxable brokerage account or a qualified, tax-advantaged vehicle such as an individual retirement account (IRA) or 401(k) plan. The location of these assets depends on your investment goals.

How much do index funds cost?

Index funds, including index ETFs, typically charge lower expense ratios than actively managed funds, as they have lower administrative and research expenses, as well as lower transaction fees.

You can contrast index fund expense ratios with large, actively managed ETFs, such as the JPMorgan Equity Premium Income ETF (JEPI), which has an expense ratio of 0.35%.

Index funds are much less costly, in comparison. For example, the expense ratios of popular US index ETFs tracking the S&P 500, Nasdaq 100 and Russell 2000 are often 0.2% or less.

As a rule of thumb, keeping your fund costs low will help boost your overall portfolio return.

Diversifying your portfolio with index funds

Because they track a wide variety of asset classes, it’s easy to use index funds for broad portfolio diversification.

“For instance, an investor looking to balance their portfolio might allocate a portion to an international index fund to complement their domestic holdings,” said Ambrose.

“This diversification can help spread risk and potentially enhance returns by tapping into different regions’ growth opportunities,” he added.

The largest non-US index ETF is the Vanguard Total International Stock ETF (VXUS), with $65.9 billion in share-class net assets as of February 29, 2024. Investors in the US, or their financial advisors, frequently use this fund, or a similar index fund, such as the iShares MSCI EAFE ETF (EFA), to gain exposure to stocks outside the US.

Additionally, Ambrose said, index funds can provide exposure to specific themes or sectors, such as technology or health care, allowing investors to capitalize on industry trends without the risk of individual stock selection.

For example, investors can get exposure to the 11 individual S&P sectors through ETFs from State Street, Vanguard, Fidelity and other major providers, allowing targeted exposure to specific areas of the market.

Index fund strategies for investors

When it comes to strategies for investing in index funds, one popular approach is dollar-cost averaging, which splits the amount invested over a period of time — days, weeks or months — rather than in one big purchase.

“By regularly investing a fixed amount, regardless of market fluctuations, investors can mitigate the impact of volatility over time and benefit from the power of compounding,” Ambrose said.

Another strategy involves rebalancing the portfolio periodically to maintain the desired asset allocations.

“This involves selling assets that have appreciated significantly and reinvesting the proceeds into underperforming assets, ensuring the portfolio remains aligned with the investor’s risk tolerance and investment objectives,” Ambrose said.

Index fund alternatives

Investors who want an alternative to index fund investing can use a technique called direct indexing. This strategy involves purchasing individual stocks in proportions that mirror an index; in other words, an investor would be replicating the index’s performance without owning the corresponding index fund itself.

This method potentially allows for tax advantages and lower fees compared to investing in index funds. Direct indexing has become more popular in recent years as trading costs have declined.

For example, many brokerages now offer commission-free online stock and ETF trades, making it easier than ever to incorporate a direct-indexing strategy.

Many advisors and asset managers also offer direct-indexing services to clients.