Low-cost index funds are an inexpensive way for people to build a diversified investment portfolio. These funds are suitable for both new and experienced investors, and the best low-cost index funds allow you to meet your investment goals while aligning with your risk tolerance and investment time horizon.
“An index fund is a way of getting broadly diversified exposure to an investment style, which can be narrowly focused on a sector or an industry or theme, or it can be as broad as all U.S. large-cap stocks or all U.S. stocks trading, period,” says Todd Rosenbluth, head of research at financial consultancy VettaFi.
What are low-cost index funds?
Index funds are pooled investment vehicles that follow a benchmark, such as the , the Dow Jones Industrial Average or the Bloomberg Barclays Aggregate, a bond index. An index fund intends to replicate the performance of an underlying index since people cannot directly invest in an index. Indexes can contain hundreds or even thousands of securities, and index funds make it easy for investors to get broad exposure by holding a single investment.
Omar Qureshi, managing partner at Hightower Wealth Advisors, says an index provider creates an index by selecting a number of securities according to a set of rules. The holdings will change infrequently, usually every quarter or annually. What makes index funds so cheap is they are passively managed, so no portfolio manager makes buying and selling decisions.
“Because you’re not paying anybody to make the individual stock decisions, your expense ratios, or your total internal cost, can be very, very low,” Qureshi says.
Basics of index fund investing
Index funds are available as both mutual funds, sometimes called traditional index funds, and exchange-traded funds (ETFs). ETFs have become very popular because, unlike mutual funds, they can trade throughout the day, are generally more tax-efficient than mutual funds and are one of the cheapest ways to own index funds.
Rosenbluth says some S&P 500 stock index ETFs cost as little as 0.03% to own annually, so for every $1,000 invested, you’d pay 30 cents a year to own it. The cheapest and most plentiful index funds are based on the major stock indexes. Specialized index funds that focus on a niche market sector, such as crude oil or emerging markets, or are based on a theme, such as robotics or cybersecurity, will cost more. However, those funds are still cheaper than actively managed funds, which carry additional costs because their investments are selected by professional portfolio managers.
Choosing a low-cost index fund
Investors have many options when seeking low-cost index funds. Firms such as Fidelity, Vanguard, BlackRock and State Street all offer these funds, as do hundreds of other providers.
You can invest in a low-cost index fund through brokerage platforms such as Interactive Brokers or E-Trade, and some providers such as Fidelity and Vanguard have their own platforms where you can buy their index funds directly.
Before buying a fund, John Jones, investment adviser representative at Heritage Financial, says investors should consider the exposure they want, such as large-cap stocks, international stocks, bonds or another type of index fund. They should look for a liquid fund so they can easily sell it when needed, says Rosenbluth. Liquidity is measured by trading volume, and a typical threshold is for a fund to trade about 100,000 shares daily.
Jones adds that investors should look at how an index is structured. Indexes weighted by market capitalization, such as the S&P 500, are most heavily weighted to the holdings with the largest market caps. For example, the top 10 holdings in the S&P 500 comprise roughly 30% of the entire index. Equal-weight indexes, like the S&P 500 Equal Weight index, weigh each holding equally so no one stock overshadows another.
Jones prefers the equal-weight index funds for long-term investors. “Do you want diversification or concentration? Sometimes you’ll unintentionally get concentration” with market-cap-weighted indexes, he says.
Rosenbluth says the easiest way to get started investing in index funds is to buy a broad-based US equity index fund, such as those tied to the S&P 500. Investors interested in building a more diverse portfolio can add small-cap index funds, international index funds and fixed-income index funds, depending on their risk tolerance.
“There’s a phrase: Time in the market is more important than timing the market,” he says. “Start investing today instead of waiting for tomorrow.”
Pros and cons of low-cost index funds
The big pros for these funds are their cost and their diversification, Qureshi says. There are plenty of fund types and styles available, so investors can construct an entire portfolio using just a few index funds and get exposure to most tradable securities. Index funds may offer long-term investors more consistency since holdings change infrequently.
Derek Miser, founder of Miser Wealth Partners, says index funds are a solid choice for someone who wants to invest in the market but isn’t a stock picker or doesn’t understand how to read company balance sheets or earnings reports. He also points to research showing large-cap indexes, such as the S&P 500, outperform the vast number of professional money managers over time.
One of the pros of index funds, that they seek to replicate the performance of an index, could be considered a con, depending on an investor’s viewpoint. Because these funds seek to mirror an index, the fund’s return will also be similar to the index, neither higher nor lower. Investors who want to beat an index like the S&P 500 will have to own a fund that actively seeks to beat the index’s return.
| Pros | Cons |
|---|---|
Low costs compared to actively managed funds | Will closely match the performance of the benchmark index, for better or worse |
Provides exposure to hundreds or thousands of securities in one fund | May pay taxable capital gains, even in down years |
Easy to understand and manage for new and experienced investors | May require long holding periods to earn high returns |
Tax considerations for low-cost index funds
You’ll generally pay fewer capital gains taxes if you own index funds, whether mutual funds or ETFs, versus an actively managed fund. But even within the index fund world, ETF index funds are more tax-efficient, Miser says.
Mutual funds must have cash on hand to buy securities when people buy the funds, and they must have enough cash to pay investors when they redeem shares, which can mean selling securities. That generates possible capital gains for investors. ETFs use “in-kind” transactions when investors buy or sell shares, and this creation and redemption process isn’t considered taxable.
Frequently asked questions (FAQs)
Fees are generally very low. Look for annual expense ratios of about 0.2% or less — sometimes less than 0.05% — for most broad-based funds.
Yes. Buying low-cost index funds is an easy way for beginners to start investing.
You can maximize your returns by looking for inexpensive funds and staying invested for the long term, which allows you to take advantage of compounding returns.
