How to invest in index funds in 2024

By:

James Knight

James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.

Updated:  Jul 5, 2023

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Index funds offer an easy, low-cost way to invest in the world’s biggest companies. In this guide, learn how to buy index funds, which funds best suit your budget, and compare the trading platforms with the lowest fees.

Quick hit: How to buy index funds in three simple steps

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What are index funds?

Index funds are investment funds that aim to replicate the performance of a specific market index, such as the S&P 500. They are designed to provide broad stock market exposure and generally hold a diversified portfolio of stocks or other assets in proportions that mirror the composition of the targeted index.

What’s the difference between ETFs and index funds?

The main difference is that ETFs (exchange-traded funds) trade on an exchange – such as the New York Stock Exchange or London Stock Exchange – throughout the day, like individual stocks, while index funds are typically bought and sold at the end of the trading day at their net asset value (NAV).

ETFs generally have lower costs and expense ratios compared to index funds, but this isn’t always the case and can vary depending on the specific fund. Index mutual funds may also have minimum investment restrictions, which do not apply to ETFs.

Are active funds better than passive index funds?

Not usually, no. Studies have shown that over the long term, a majority of actively managed funds fail to consistently beat their respective benchmarks. Active funds tend to have higher expense ratios than passive funds as well, as they have to pay the costs associated with professional fund managers.

Passive tracker funds, on the other hand, offer broad diversification across an entire index, reducing the risks associated with individual stock selection. They are cheaper to invest in and have far more consistent performance. 

Though, of course, when you purchase index funds you can’t outperform the benchmark index. Whereas it is possible for an actively managed fund to do significantly better than the benchmark over a set period of time (if not usually over the long term)

How do index funds work?

Index funds work by holding a portfolio of assets that mimic the composition of a particular stock market index. An index fund aims to replicate the targeted index by owning all (or a representative sample) of the securities in the index in the same proportions as the index.

Periodically, the fund will ‘rebalance’ its holdings. That is, adjust the stocks it owns to match any changes in the index’s composition, ensuring that it continues to track the index accurately.

Depending on whether the index fund is an ‘income’ fund or an ‘accumulation’ fund, it will either periodically distribute dividends earned by the underlying securities to index fund investors, or reinvest the money in more shares and bonds to continue the growth of the fund.

What index fund should I invest in?

There are a huge variety of options available and the right decision depends on your investment goals, budget, risk tolerance, and interests.

Each index fund tracks a particular stock index, and the best option for beginners is to choose one that tracks a large, popular index from a developed economy. The most obvious picks are to invest in an S&P 500 index fund or choose one of the best UK index funds.

Two examples of S&P 500 mutual funds are the Fidelity 500 Index Fund (FXAIX) and the Vanguard 500 Index Fund (VFIAX). For the FTSE 100 in the UK, you might consider either the Vanguard FTSE 100 Index Unit Trust (VAFTIGI) or the HSBC FTSE 100 Index Fund (HCOIA).

The FTSE 100 and the S&P 500 track large-cap stocks, as does the Dow Jones Industrial Average (DJIA). If you are a little more experienced or have a greater appetite for risk, you might consider investing in mid-cap or small-cap companies by investing in index funds that track the Russell 2000, or the S&P SmallCap 600.

Alternatively, you may want to branch out into other countries and invest in developing economies, or established markets in Asia or mainland Europe. Investing in the Hang Seng Index is a route into the Chinese market, while the Nifty 50 contains large-cap stocks in India. These index funds tend to be more risky, but have greater potential for growth.

Whichever option you choose, it’s a good idea to invest in mutual funds that are managed by large asset management companies.. The best Vanguard index funds, for example, are generally the largest, which makes them more stable. Vanguard and BlackRock index funds also contain lots of institutional investors, which makes it less likely that sudden outflows will disrupt the performance of the fund.

How much should I invest in index funds?

The amount you should invest in index funds depends on your personal financial situation, goals, risk tolerance, and investment strategy. However, there are some guidelines to help you decide what’s best for you.

1. Determine your financial goals. What are you investing for? Is it retirement, short-term goals, or long-term wealth accumulation? This will help you establish a target amount and time horizon for your investments.
2. Build an emergency fund. Before investing in index funds, it’s advisable to set aside an emergency fund with 3-6 months’ worth of living expenses. This fund ensures you have a safety net for unexpected expenses or financial emergencies. You should also consider if paying off any debts – like a student loan – is a better use of your money.
3. Assess your risk tolerance. Consider how comfortable you are with the potential fluctuations and volatility of the stock market. Index funds can provide stability, but they are still subject to market risks, and you have to have the mentality to cope with watching your investments go down as well as up.
4. Start with a percentage of your income. As a general rule of thumb, aim to save and invest 10-20% of your income every month. However, this percentage can vary based on your individual circumstances. Start with an amount that you can comfortably afford without jeopardising your basic needs and other financial obligations.
5. Dollar-cost averaging. Rather than investing a lump sum, you can spread your investments over time through regular contributions. This approach, known as dollar-cost averaging, can help mitigate the impact of short-term market fluctuations, particularly if you dollar-cost average into a broad market index that tracks large stock market indices.
6. Consider regular contributions. Set up automatic contributions to your index fund(s) on a regular basis, such as monthly or quarterly. This approach allows you to consistently invest and potentially benefit from the power of compounding over time.
7. Gradually increase your investments. As your financial situation improves, consider increasing your investments in index funds. This can be through additional contributions or reallocating funds from other investments.
8. Seek professional advice. If you’re unsure about the appropriate amount to invest in index funds, it may be helpful to consult with a financial advisor. They can provide personalised guidance based on your specific circumstances and goals.

How much do index funds cost?

Index funds can cost as little as 0.05-0.5% of your investment, per year. That means that if you invested $1,000, you would pay between $1-$5 per year in fees.

There may also be a small trading fee when you make your initial investment, though this varies depending on the brokerage account you use.

Index fund costs are broken down differently to regular stock market investing. Here are some common costs to look out for with stock index funds:

• Expense ratio. The expense ratio is an annual fee charged by the fund provider to cover the operating expenses of the fund. It is expressed as a percentage of the fund’s average net assets. Index funds are known for their low expense ratios compared to actively managed funds. Low cost index funds often boast expense ratios that range from 0.05% to 0.50%, or even lower.
• Transaction fees. Some investment platforms or brokerages may charge transaction fees, also known as trading fees or commissions, for buying or selling index funds. However, many brokers now offer low fees or commission-free trading for certain index funds.
• Brokerage account fees. Depending on the brokerage firm, there may be account maintenance fees or minimum balance requirements associated with holding index funds in a brokerage account. It’s important to review the fee structure of the brokerage you choose.
• Additional costs. Some index funds may have additional costs, such as shareholder service fees, redemption fees for short-term trading, or account transfer fees. These costs can vary among different fund providers, so it’s important to read the fund’s prospectus and fee disclosures.

When comparing index funds, it’s most important to consider the expense ratio/management fees. Lower expense ratios can have a substantial impact on long-term investment returns, as expenses directly reduce your net returns.

It’s worth noting that certain brokerage firms and fund providers sometimes offer their own index funds with very competitive expense ratios. Additionally, exchange-traded funds (ETFs), which are similar to index funds, may have lower expense ratios due to their structure.

Should a beginner invest in index funds?

Index funds can be an excellent choice for beginners due to their simplicity, diversification benefits, and low costs. Mutual funds are straightforward investment vehicles that provide exposure to a broad market without the need for active stock picking.

By investing in an index fund, beginners add a wide range of stocks to their investment portfolio, reducing the risks of picking individual stocks – a risk that’s heightened for anyone new to the market.

Index funds generally have lower expense ratios compared to actively managed funds, while it’s cheaper to invest in a fund rather than paying trading fees every time you buy an individual stock.

What are the risks of buying an index fund?

While index funds are generally considered less risky than individual stock investing, they still carry some risks that investors should be aware of.

The first is that any index fund is subject to market volatility and the natural ebbs and flows of the stock market. If the overall market declines, the value of the mutual fund will also decrease, and sometimes that decrease can be substantial.

Second, while index funds aim to track the performance of an index, they may not perfectly match it due things like expenses and sampling methods. Generally, this will only be a small disparity, but it can sometimes become a larger one if the fund is set up poorly.

Finally, because index funds are passively managed, there’s no way they can take advantage of potential opportunities or react quickly to changing market conditions. You’ll never be able to outperform the benchmark when you invest in an index fund.

Bottom line

Index funds are a cheap investment vehicle that are easily accessible to beginners. Investing in an index fund can be a great way to create a portfolio without much experience and without needing to dedicate too much time to picking individual stocks.

Passive index funds generally outperform actively managed funds over a long period of time, and the costs are much lower to boot. While you’ll never be able to outperform the market this way, mutual funds are ideal for anyone who’s looking for a ‘set and forget it’ way to invest.

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