What is an index fund, and why do fees matter so much?

An index fund is a fund that buys every stock or bond in a market index, so one purchase spreads your money across hundreds or thousands of companies. Because it just copies the index, it can charge a very low yearly fee, and over decades a low fee can leave you with tens of thousands of dollars more.

It copies a list instead of picking stocks

An index is a list of investments, like the 500 large US companies in the S&P 500. An index fund buys what is on the list and holds it. No one is trying to guess which stocks will win.

The expense ratio is the yearly fee

It is a percentage of your balance taken out each year. A 0.05% fee costs $5 a year on $10,000. A 1% fee costs $100 on the same balance, and that gap grows as your balance grows.

One fund can hold the whole market

A broad index fund spreads your money across many companies and industries. If one company fails, it is a small slice of what you own.

Returns are never promised

Index funds go up and down with the market. They can lose money in a year, or over several years. Money you need within about 5 years belongs in savings, not stocks.

How an index fund works

A fund pools money from many people and buys investments with it. Each person owns shares of the fund, and the fund owns the stocks or bonds. When the investments rise or fall in value, so do your shares.

Most funds fall into two groups. An actively managed fund pays people to pick investments they think will do better than the market. An index fund skips the picking and buys everything in an index. That takes less work, so the fees are usually much lower.

What an expense ratio costs you

The expense ratio is listed as a percentage, like 0.05% or 1%. You never get a bill for it. The fund takes it out of its assets bit by bit, so your return is just a little lower than the index each year.

A small percentage sounds harmless, but it comes out of your whole balance every year, not only your gains. Money lost to fees also stops growing, so the cost compounds the same way your returns do. The worked example below shows how 0.05% and 1% play out over 30 years.

You can find the expense ratio on the fund's fact sheet or in its prospectus. Look for other costs too, like sales loads (a fee to buy or sell) or account fees from the place that holds your fund.

Why diversification helps

Owning one company's stock is a bet on one company. If it has a bad year or goes out of business, a big part of your money goes with it. A broad index fund owns hundreds or thousands of companies, so no single one can sink you.

Diversification lowers the risk of one company or one industry. It does not remove market risk. When the whole market drops, a broad index fund drops too. That is why time matters: the longer you can leave the money alone, the more room it has to recover from bad years.

ETF or mutual fund

An index fund can come as an exchange-traded fund (ETF) or a mutual fund. Both can track the same index and hold the same stocks. The difference is mostly how you buy and sell them.

An ETF trades on a stock exchange during the day, like a stock, at whatever the price is at that moment. A mutual fund is bought and sold once a day at a price set after the market closes. Some mutual funds have a minimum first purchase. ETFs can often be bought in small amounts, and some brokerages let you buy part of a share.

In a taxable brokerage account, ETFs often pass on fewer capital gains each year, which can mean a smaller tax bill. Inside a 401(k) or IRA, that difference does not matter. Pick whichever your account offers at the lowest total cost.

Picking a fund

Start with what your account already offers. In a workplace 401(k), look through the fund list for names with "index" in them and compare expense ratios. In an IRA or brokerage account, a broad US stock index fund, a total world stock index fund or a target-date index fund are common starting points.

Compare funds that track the same kind of index. Two funds that both track the S&P 500 should behave almost the same, so the cheaper one is usually the better pick.