How to Invest in Index Funds and Best Index Funds of April 2023 - NerdWallet (2024)

Index funds are a great investment for building wealth over the long-term, which is why they are popular with retirement investors.

What is an index fund?

"Index funds" mirror the performance of an existing collection of stocks, such as the Standard & Poor’s 500 index. If you invest in an index fund that tracks the S&P 500 you'll be invested in all of the companies within that index.

Since index funds are fairly hands-off, and you could build a diversified portfolio earning solid returns using mostly this type of investment. That's because index funds don’t try to beat the market, or earn higher returns compared with market averages. Instead, these funds try to be the market — buying stocks of every firm listed on an index to mirror the performance of the index as a whole.

Index funds can help balance the risk in an investor's portfolio, as market swings tend to be less volatile across an index compared with individual stocks.

How index funds work

Index funds work by investing with a passive management strategy rather than an active management strategy. Active management is when an investment manager actively chooses when to buy or sell specific investments. Since there is someone doing the work of choosing these investments, the management fees for actively managed investments tend to be higher. Many mutual funds use active management strategies.

Passive management, on the other hand, is a strategy where a fund manager builds a portfolio of investments that reflect an existing market index. A market index is a collection of a group of stocks that reflects a particular part of the economy. For instance, the S&P 500 is a stock market index that measures the performance of about 500 companies in the U.S. Typically, the S&P 500's performance offers a picture of the health of the U.S. stock market and the broader economy.

An index fund will be made up of the same investments that make up the market index it tracks. This way, the performance of the index fund usually closely mirrors that of the index, no hands-on management necessary.

Why invest in index funds?

Despite the fact that fund managers do a lot of work to "beat the market" (namely, a market index), they very rarely do. And if they do, it's highly unlikely that they will continue to beat the market over the long term.

According to SPIVA, which is a part of S&P Global, only 29% of actively managed funds beat the S&P 500 in 2019. In 2021, only 9% of those funds continued to beat their benchmark.

Because actively managed funds often underperform the market, and index funds match it, passively managed index funds typically bring their investors better financial returns over the long term. Plus, they cost less.

What is an index?

For investors, an index is a collection of a group of securities, such as stocks, that are used to measure the health of the broader market. When you hear newscasters talk about the ups and downs of "the Dow," they are talking about how well a specific index — the Dow Jones Industrial Average — performed that day.

As the name suggests, an index fund tracks a particular benchmark index. Some common benchmarks for index funds include:

Index examples

How much do index funds cost?

Index funds have fewer fees that erode your returns than actively managed funds. The cost of commissions and management of the account, known as expense ratios, are lower for index funds, since they require less work than managed accounts. You're not paying for someone to study financial statements and make calls on what to buy. Index funds may be less expensive than other funds, but they can still incur some costs. Here are the important ones:

Diversifying with index funds

Index funds are available across a variety of asset classes. Investors can buy funds that focus on companies with small, medium or large capital values, or focus on a sector like technology or energy. These indexes are perhaps less diversified than the broadest market index, but still more so than if you were to buy stock in a handful of companies within a sector.

Individual stocks may rise and fall, but indexes tend to rise over time. With index funds, you won’t get bull returns during a bear market. But you won’t lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.

What are the best index funds?

Index funds work by tracking specific market indices. So you'll need to know which market index you want your index fund to track before you start investing. Here are some of the top index funds that track some of the most popular indices.

Here are some of the best index funds pegged to the S&P 500.

Data current as of April 4, 2023. For informational purposes only.

Vanguard 500 Index Fund Admiral Shares (VFIAX)

Also known as the Vanguard S&P 500 Index fund, this fund was founded in 1976 and is the granddaddy of all index funds. Like the other S&P 500 funds on this list, this fund gives exposure to 500 of the largest U.S. companies, which make up about 75% of the U.S. stock market’s total value.

Schwab S&P 500 Index Fund (SWPPX)

As research firm Morningstar notes, this is one of the cheapest and most accessible S&P 500-tracking funds out there. Launched in 1997, this Schwab fund charges a scant 0.02% expense ratio and requires no minimum investment, making it attractive for investors concerned about costs.

Fidelity 500 Index Fund (FXAIX)

Founded in 1988 (formerly known as Institutional Premium Class fund), Fidelity removed this fund's investment minimum so investors with any budget size can get into the low-cost index fund action.

Fidelity Zero Large Cap Index (FNILX)

In the race for the lowest of the low-cost index funds, this Fidelity fund made news by being among the first to charge no annual expenses, meaning investors can keep all their cash invested for the long run.

T. Rowe Price Equity Index 500 Fund (PREIX)

Founded in 1990, the fund’s expense ratio is competitive with other providers, but the $2,500 minimum may be steep for beginning investors.

What are the best Nasdaq index funds?

Here are some of the best index funds pegged to the Nasdaq.

Data current as of April 4, 2023. For informational purposes only.

Invesco NASDAQ 100 ETF (QQQM)

QQQM includes 100 of the biggest nonfinancial companies listed on the Nasdaq. It also includes at least 90% of the assets on the NASDAQ-100 index and is rebalanced quarterly.

QQQM has an expense ratio of 0.15%, meaning for every $1,000 invested you'd pay a $1.50 fee annually.

Invesco QQQ (QQQ)

QQQ holds 101 companies, tracks the NASDAQ-100, and has $151.51 billion in assets under management.

QQQ has an expense ratio of 0.20%, meaning for every $1,000 invested you'd pay a $2 fee annually.

Fidelity NASDAQ Composite Index Fund (FNCMX)

FNCMX aims to mirror the performance of the Nasdaq Composite index. The fund usually holds 80% of stocks included in the index. In addition to the typical sectors represented by a Nasdaq index fund (such as information technology, consumer services and health care), FNCMX also includes the real estate and material sectors.

FNCMX has an expense ratio of 0.37%, meaning for every $1,000 invested you'd pay a $3.70 fee annually.

Quick start guide: How to invest in index funds

Investing in index funds is easy. Here's a quick rundown of how to do it:

1. Have a goal for your index funds

Before you start investing in index funds, it's important to know what you want your money to do for you. If you're looking to make a mint in a few years and are willing to take a lot of risk, you may be more interested in individual stocks or even cryptocurrency.

But if you're looking to let your money grow slowly over time, particularly if you're saving for retirement, index funds may be a great investment for your portfolio.

2. Research index funds

Once you know what index you want to track, it's time to look at the actual index funds you'll be investing in. When you're investigating an index fund, it's important to consider several factors. Here are some things to keep in mind:

Despite the array of choices, you may need to invest in only one. Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your allocation if you want additional exposure to specific markets in your portfolio (such as more emerging market exposure, or a higher allocation to small companies or bonds).

3. Pick your index funds

Once you've decided which index you're interested in, it's time to choose which corresponding index fund to buy. Oftentimes, this boils down to cost.

Low costs are one of the biggest selling points of index funds. They’re cheap to run because they’re automated to follow the shifts in value in an index. However, don’t assume that all index mutual funds are cheap.

Even though they’re not actively managed by a team of well-paid analysts, they carry administrative costs. These costs are subtracted from each fund shareholder’s returns as a percentage of their overall investment.

Two funds may have the same investment goal — like tracking the S&P 500 — yet have management costs that can vary wildly. Those fractions of a percentage point may seem like no big deal, but your long-term investment returns can take a massive hit from the smallest fee inflation. Typically, the bigger the fund, the lower the fees.

4. Decide where to buy your index funds

You can purchase an index fund directly from a mutual fund company or a brokerage. Same goes for exchange-traded funds (ETFs), which are like mini mutual funds that trade like stocks throughout the day (more on these below).

When you're choosing where to buy an index fund, consider:

5. Buy index funds

In order to purchase shares of an index fund, you'll need to do so from an investment account. You can then open an investment account, such as a traditional brokerage account or a Roth IRA, through the brokerage you picked in step 3. You can then buy the fund from that account.

When you go to purchase the fund, you may be able to select a fixed dollar amount to spend or choose a number of shares. The share price of the index fund, and your investing budget, will likely determine how much you're willing to spend. For instance, if you have $1,000 you'd like to invest in an index fund, and the fund you're looking at is selling for $100 a share, you'd be able to purchase 10 shares.

6. Keep an eye on your index funds

Index funds have become one of the most popular ways for Americans to invest because of their ease of use, instant diversity and returns that typically beat actively managed accounts. But passive management doesn't mean you should completely ignore your index fund. Here are some things to think about over time:

Is now a good time to invest in index funds?

Whether the market is down or up, now is always a better time to start investing than later — as long as you're investing for the long-term in a well-diversified portfolio. If the market is down, it's essentially on sale, and you can pick up the same index fund for less.

Is investing in index funds dangerous?

As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time. You may then be able to sell that investment for a profit — especially if you purchase that index fund when the market is down. That way, you're essentially buying the index fund when it's on sale

Are index funds good for beginners?

If you’re planning to invest for the long-term, dips or highs in the market become less relevant. If you’re worried about buying an index fund at a high, keep in mind that if you’re invested in that fund for many years, that high will look much smaller down the road. Check out our investment calculator to explore how an investment in an index fund or other security could grow over time.

Are index funds popular?

Since the first index fund was introduced in 1976 index funds have become incredibly popular. Currently, investors are pulling their money out of actively managed funds and investing more heavily in U.S. stock index funds. According to Morningstar, actively managed funds lost $926 billion in 2022 while passive funds gained $556 billion.