How To Buy Index Funds
Index funds purchase baskets of securities to track the performance of market indexes, like the S&P 500. Index funds are investment and retirement portfolio staples thanks to their low cost and ease of diversification. Here’s how you can get started buying index funds to help you reach your retirement and investing goals.
1. Open a Brokerage Account
You’ll need an investment account to buy index funds. Different kinds of investment accounts are best suited for different types of goals:
- Mid- and Long-Term Goals. Taxable accounts allow you to build wealth through investing but require you to pay taxes whenever you receive dividends or make a profit off of investment sales. Taxable accounts are helpful for those looking to reach large money goals before retirement or for those who have already maxed out their retirement accounts for the year.
- Retirement. Retirement accounts, such as a traditional IRA or a Roth IRA, offer certain tax advantages to help you save for retirement. These accounts are built for long-term saving, and if you try to make withdrawals before you turn 59 ½, you will probably owe a 10% penalty as well as taxes on any money that hasn’t been taxed before.
- Educational Expenses. People looking to help their children with educational expenses should consider 529 accounts. These accounts offer similar tax advantages as retirement accounts—you may be able to deduct contributions from your taxes and investments grow tax free while they’re in the account. What’s more, you won’t pay taxes on any withdrawals used for eligible education expenses, which now include tuition for primary and secondary schools as well as broader educational costs associated with higher education and trade schools.
- Children. Custodial accounts, sometimes called UTMA/UGMA accounts, let you invest on behalf of a child. Funds in the account can be used for an expense that benefits the child and become fully the child’s when they reach a legally designed age, usually 18 to 25, depending on the state the account is held in.
If you choose an online brokerage account, you buy and sell your own investments, and fees tend to be minimal. If you choose a managed brokerage account with a human investment advisor, you’ll generally pay a percentage of assets each year to have someone manage your investments for you, such as 1% of assets.
You can also opt for a robo advisor account. Answer some questions about your risk tolerance, timeline and goals, and an algorithm recommends a portfolio mix for you. This is convenient, but you’ll pay higher fees than it would cost you on your own. Robos like Betterment and Wealthfront, for instance, charge 0.25% of assets each year. (So someone with $10,000 in an account would pay $25 a year in fees.)
2. Decide on Your Index Fund investment Strategy
Your index fund investment strategy takes into account your overall financial goals, risk tolerance and timeline. If you’re working with a financial advisor, they’ll help you determine the best mix of funds for your situation. If you open an account with a robo-advisor, the algorithm will suggest a strategy based on your answers to questions when you open the account.
If you’re choosing an index fund allocation on your own, it may help to use an online tool to steer you in the right direction. Vanguard, for instance, offers an online questionnaire on your timeline, risk tolerance and investing preference to recommend an index fund asset mix for you. Fidelity offers investment tools you can use without creating an account, such as the ability to create an investment strategy.
In general, advisors recommend keeping more of your portfolio in stocks and less in fixed-income products like bonds when you’re further from a goal. As you get closer to the goal, gradually adjust the mix away from stock and into bonds.
How aggressive you are—reflected in the ratio of stock index funds to bond index funds—depends on how much risk you’re willing to take on. For shorter term goals less than three years away, you may be better off with high-yield savings accounts or certificates of deposit (CDs). For longer-term goals that are more than three to five years out, consider taking on more risk by investing in stock index funds.
3. Research Your Index Funds
It’s important to know what you’re getting in an index fund, so research is key.
First, pick an index—or more than one index. The S&P 500 is probably the most well-known index, but there are also indexes based on company size, business sector and market opportunity, such as emerging markets. Equity indexes are generally well suited to adding growth potential (and risk) to your portfolio, and the more niche your equity index, generally the more risk you’re taking on. Bond-based indexes add stability to investment portfolios and more modest returns.
Indexes to start your search with include:
- Broad market indexes like the Dow Jones Industrial Average, S&P 500 Index, NASDAQ and Wilshire 5000 Index. Funds tracking one of these core indexes are commonly chosen by those looking to construct simple two- or three-fund portfolios.
- Equity indexes that group companies by size like the Russell 3000 Index (large-cap companies), Russell 2000 Index (small-cap companies) and S&P 400 Index (mid-cap companies). Generally, the smaller the companies in an index, the more risk and growth potential you take on.
- Indexes offering exposure to stocks from companies outside of the U.S., like the MSCI Indexes. Usually, the less developed a country’s economy, the more risk and growth potential you take on.
- Indexes based in the bond and fixed income markets, such as the Barclays Capital Aggregate Bond Index. Indexes with corporate bonds typically offer higher returns (and more risk) than those that only invest in government bonds.
Once you’ve settled on an index or indexes, you’re ready to research individual funds. When you’re comparing index funds, here are some things to consider:
- Expense Ratio. This is the cost to administer the fund each year. All things being equal, index funds based on the same index all track the same thing, so expense ratio can be a big deciding factor. If one fund charged 0.19% and another charged 0.03%, you’d save $16 a year per $10,000 you invested by going with the lower cost fund.
- Other Fees. You can generally avoid trading fees on index funds at most major brokerages, but be sure to look out for loads, or special fees charged by certain mutual funds when you buy or sell them. You should be able to find index funds for any index without load fees at most major brokerages, so don’t opt for a fund with loads just because it’s the first you’ve found.
- Investment Minimums. If you don’t have the cash to meet the minimum investment required, you can cross that fund off your list. If you really want to buy into that particular index, you should look for the exchange-traded fund (ETF) version of that fund, which will typically have no minimum beyond the price of one share.
Keep in mind that index funds tracking the same index at different companies will have virtually identical holdings, so expenses should be your primary focus.
“In reality, if you choose an index like the S&P 500, and you start to say, ‘Do I want Vanguard, Fidelity or Schwab,’ they’re essentially the same,” says Ron Guay, a certified financial planner (CFP) in Sunnyvale, Calif. “You’re buying the same content, and you’re just choosing a different wrapper or brand.” That means you’ll want to pay attention to expense ratios, trading fees and loads. You’ll probably want to choose the index funds offered in-house by your brokerage of choice to minimize fees.
4. Buy the Index Funds
Once you have a brokerage account, you can buy shares of the index funds you’ve settled on. Generally, you’ll search for or type in the ticker symbol of the fund you want to purchase and the dollar amount you want to invest.
You’ll need to buy enough to reach the fund’s investment minimum, but after you do, you can typically buy fractional shares going forward. The site may ask for your preference regarding dividends—whether they should be used to purchase additional fund shares or deposited into your account as cash. If you’re reinvesting for the long term, most experts recommend you reinvest your dividends because historically dividends have been responsible for substantial investment growth.
5. Set Up Your Purchase Plan
Investing is typically an ongoing practice, so you’ll need to think about your plan for buying index funds over time. Financial advisors often recommend dollar-cost averaging—the practice of putting a certain amount of money into your investments at set intervals.
“The beauty of dollar cost averaging is that investors add to their portfolio in high and low markets, eliminating the emotional push to buy high and sell low,” says Erika Safran, a CFP in New York City.
To make this happen, set up automatic investments that happen on a schedule (such as once a month or every payday) with your brokerage. This ensures that you’ll continue to invest on a regular schedule.
In general, investing is about the long game: Although the stock market has its short-term ups and downs, over your investing life, buying and holding a diverse investment mix historically results in successful returns.
For best results, review your portfolio every six to 12 months and rebalance when your investments have drifted too far from your original allocation. To rebalance, you’ll sell some of the categories that have gotten too large and buy more of the category that’s gotten too small. This helps keep your portfolio on track to reach your goals.
6. Decide on Your Exit Strategy
Although buying and holding is a solid investment strategy, you should also think about when and how you’ll sell your shares. If you’re investing in a taxable account, you’ll have to consider capital gains taxes and whether you can offset gains with losses in other investments through a process called tax-loss harvesting. If you’re in a tax-advantaged retirement account, you’ll want to brainstorm ways to minimize the taxable income you earn each year through retirement account withdrawals. A financial advisor or tax professional can help you figure out the best strategies for managing withdrawals from any type of investment account.
Index Fund FAQs
What Is an Index Fund?
An index fund is a type of mutual fund that closely tracks a market index, such as the S&P 500 or the Russell 2000. It’s considered a passive investment, in that fund managers work to replicate the holdings of a particular benchmark index and changes are only made as the index itself makes changes. Because no proprietary research or frequent trades occur, fees are lower for index funds than for actively managed funds. Performance of index funds has historically exceeded that of actively managed funds overall.
What’s the Difference Between an Index Fund and an ETF?
The biggest difference between an index fund and an ETF is the way they’re traded. An ETF is traded like a stock—you can buy and sell it throughout the day. An index fund can only be bought and sold at the price set when the trading day ends.
What Are the Best Index Funds to Buy?
Generally, if you’re choosing index funds, your portfolio will probably contain a fund that tracks the general market, such as an S&P 500 index fund. For some people, this may be the only fund they buy. Low-cost index funds that track the S&P 500 at major brokerages include:
- Fidelity 500 Index Fund (FXAIX)
Minimum investment: $0
Expense ratio: 0.015%
- Schwab S&P 500 Index Fund (SWPPX)
Minimum investment: $0
Expense ratio: 0.020%
- Vanguard 500 Index Fund Admiral Shares (VFIAX)
Minimum investment: $3,000
Expense ratio: 0.040%
- T. Rowe Price Equity Index 500 Fund (PREIX)
Minimum investment: $2,500 (when opening an account)
Expense ratio: 0.19%