Guide to Low-Cost Index Funds

Few investment products have been as long-lived or successful as the humble index fund. Originally launched in 1976 by the late founder and chairman of Vanguard, John “Jack” Bogle, index funds cemented their place in the portfolios of retail investors due to a combination of low costs, accessibility and transparency.

“Index funds offer low-cost, broadly diversified access to major asset classes like stocks and bonds,” says Rodney Comegys, global head of Vanguard’s Equity Investment Group. “Broad diversification helps to spread investment risk, while low costs allow investors to keep more of their returns and compound those savings over time.”

They’re also surprisingly effective when it comes to maximizing long-term returns. As of June 30, 2022, the SPIVA Scorecard from S&P Dow Jones Indices found that 89% of U.S. large-cap funds underperformed the S&P 500 Index over the past 15 years. By buying an index fund and holding it for the long term, investors can reap returns that beat the majority of actively managed funds.

That being said, index investing still carries some intricacies that investors should know about. Understanding these key details and nuances can help investors optimize their portfolio in terms of tax efficiency, fees and asset allocation.

Read further to find out what the experts have to say on the following topics:

What Is an Index Fund?

Before buying an index fund, investors must first understand indexes. Indexes are created by organizations like S&P Dow Jones Indices, MSCI and FTSE to categorize and track different types of securities, which can include stocks, bonds or even commodities, according to preset rules.

For example, the famous S&P 500 Index tracks a portfolio of about 500 large-cap U.S. stocks selected by an S&P Dow Jones committee, while the Bloomberg U.S. Aggregate Bond Index, also known as “the Agg,” tracks a universe of U.S. investment-grade bonds.

Each index has its own methodology that determines which securities are held, how the index is weighted and what the index’s rebalancing and reconstitution schedule is. As a result of their mechanical and rules-based nature, indexes are often used as benchmarks.

However, most investors cannot invest directly in an index. While services like direct indexing are on the rise, they tend to be expensive and inaccessible for the average retail investor. Instead, investors can gain exposure to the returns of an index by buying into an index fund.

“Index funds are simply investment vehicles that track a certain index benchmark by replicating its holdings,” says Anessa Custovic, chief investment officer at Cardinal Retirement Planning. “For example, the SPDR S&P 500 ETF (ticker: SPY) holds almost all of the S&P 500 index constituents in order to track its performance as close as possible,” she says.

Index Mutual Funds Versus ETFs

The first step before buying an index fund is determining the fund structure to utilize. This usually boils down to two choices: mutual funds and exchange-traded funds, or ETFs. Both mutual funds and ETFs are capable of tracking an index benchmark, but there are some crucial differences in their structure.

Mutual funds are the traditional option for many investors, especially in a 401(k) plan. The net asset value, or NAV, of these funds is priced once a day at market close. Mutual fund units can usually be purchased in any amount desired, subject to minimum requirements by the fund.

On the other hand, ETFs trade throughout the day on exchanges like stocks do, with a share price. While the share price can diverge from the NAV occasionally, the ETF creation mechanism tends to arbitrage this away quickly. With an ETF, the minimum investment is simply the cost of a single share.

“We’ve seen a trend where new and experienced investors are moving from index mutual funds to index ETFs due to the tax efficiency of the latter,” says Neil Pardasani, managing director and senior partner at Boston Consulting Group. Mutual funds can spit out taxable capital gains as a result of portfolio turnover, whereas the ETF structure can mitigate or even eliminate this issue.

How to Invest in Index Funds

“You can purchase most index mutual funds directly from the fund company or through a brokerage account,” says Andrew Latham, managing editor at SuperMoney. Keep in mind that investors buying in an employer-sponsored plan like a 401(k) may have a more limited selection of funds.

On the other hand, index ETFs can be purchased like any other stock in a brokerage by searching up their ticker symbol. Finally, investors who use robo-advisor services may automatically be invested in a portfolio of underlying index mutual funds or ETFs managed on their behalf.

That being said, blindly buying a random index fund won’t set an investor up for success. “When buying an index fund, the most important thing to consider is the goal for the investment,” says Daniel Gilham, managing director of advisor strategy at Farther. “Making decisions to invest in one index or another in a myopic way leaves gaps in the financial plan, which presents risks,” he says.

Pardasani echoes the need for planning. He suggests investors consider the following steps when initially selecting index funds and setting up a portfolio:

Once an investor has their index fund portfolio set, there are several steps they can undertake to optimize it over the years. Latham suggests the following:

Considerations When Buying an Index Fund

“The key to understanding how index funds work is simple – the more you pay in fees, the less you keep in returns,” says Comegys. Investors should focus on an index fund’s expense ratio, which is the annual percentage fee deducted from an investment.

“In addition to a fund’s management fees, other factors like administrative fees, distribution costs, marketing costs and compliance fees all roll into the expense ratio,” says Pardasani. For example, a fund with an expense ratio of 0.03% works out to around $3 in annual fees for a $10,000 investment.

High expense ratios can cause index funds to lag their benchmark index over time, called tracking error. “Ideally, index funds should closely track their underlying benchmarks, so investors know they’ll get the benchmark return – not significantly more or less,” says Comegys.

When it comes to index mutual funds, investors should be aware of any minimum requirements for initial and subsequent investments. For index ETFs, investors should be careful to watch the bid-ask spread and any commissions when trading.

Finally, investors should consider broad factors associated with making any investment. This includes assessing the historical volatility of the fund, its underlying assets, its track record, the fund management team and its popularity as measured by its assets under management.