Index Funds for Beginners, Explained

Index funds for beginners are the simplest way to own a large slice of the market in one purchase. An index fund is a mutual fund or exchange-traded fund (ETF) that aims to match the return of a market index, such as a broad stock market index, before fees, rather than trying to beat it.

That "don't try to beat it" design is why index funds are usually cheap, widely diversified and easy to understand. It's also why they fall when the market falls. This guide explains how they work, how to compare them and where they fit in a beginner's plan to start investing. We describe what to look for; we don't recommend any specific fund.

What is an index fund?

An index fund is a pooled investment that holds the same securities as a chosen index, or a representative sample of them. When you buy a share of the fund, you own a small piece of everything it holds.

The SEC's Investor.gov defines an index fund as a mutual fund, ETF or unit investment trust that follows a passive strategy designed to achieve approximately the same return as a particular index before fees. An index itself is just a list of securities with rules for what's in it. Examples of what an index can track:

• A whole stock market: thousands of companies of all sizes.
• Large companies: for example, the roughly 500 large US companies in the S&P 500, or the 100 in the UK's FTSE 100.
• International or global markets: companies outside your home country.
• Bonds: government or corporate debt.
• A sector or theme: technology, healthcare, clean energy. These are much narrower.

How do index funds work?

The fund manager buys what's in the index and adjusts when the index changes. There's no team trying to pick winners.

Investor.gov notes that passive management usually means less trading (lower transaction costs), fewer realised capital gains (often better tax treatment) and lower fees than actively managed funds. It also warns that over time, higher fees can significantly lower investment returns.

You make money from an index fund in the same ways as any fund: dividends or interest passed through to you, capital gains distributions, and a rising share price when the underlying holdings go up in value. You lose money when they go down.

Index fund vs ETF vs active fund: what's the difference?

"Index" describes the strategy; "ETF" and "mutual fund" describe the wrapper. That's why the terms overlap.

Investor.gov notes that ETFs often have fewer capital gains distributions than mutual funds because of how they trade, which can mean lower taxes in a taxable account. For more on how these fit with individual stocks and bonds, read stocks vs ETFs vs bonds.

Why do beginners like index funds?

Three reasons: diversification, low cost and fewer decisions.

1. Diversification: one purchase can spread your money over hundreds or thousands of companies, so no single failure sinks you.
2. Low cost: less trading and no stock-picking team usually means a lower expense ratio.
3. Simplicity: you don't have to research individual companies or time the market.

That's why broad index funds often show up on lists of the best investments for beginners. But "simple" isn't "safe". An index fund that tracks stocks will have stock-market swings.

How do you compare two index funds?

Check what it tracks, what it costs and how well it tracks. Here's a checklist you can use with any fund's fact sheet or prospectus:

• The index: is it broad (whole market) or narrow (one sector)? Broader usually means more diversification.
• Expense ratio or ongoing charge: the annual cost as a percentage of your investment. Lower is better when two funds track similar indexes.
• Other costs: account or platform fees, trading commissions and, for ETFs, the gap between buy and sell prices.
• Tracking difference: how closely the fund's return has matched its index over time, after costs.
• Size and structure: very small or unusual funds can be closed or merged.
• Currency and location: in the UK, Canada and Australia, check whether a fund holds overseas assets and how currency moves could affect you.

Why the fee matters so much

The SEC's fee bulletin uses a hypothetical $100,000 investment growing at 4% a year for 20 years. With a 0.25% annual fee, it ends at about $208,000; with 0.50%, about $198,000; with 1.00%, about $179,000. The market was identical in every case. Only the fee changed.

What are the risks of index funds?

Index funds remove the risk of picking the wrong company, not the risk of the market itself.

• Market risk: if the index drops 30%, a fund tracking it drops roughly 30% too.
• Concentration: many indexes weight companies by size, so a few very large companies can make up a big share of the fund.
• Narrow indexes: sector and theme funds can be very volatile.
• No downside cushion: an index fund won't move to cash in a crash; it stays invested by design.

Investor.gov notes that, historically, large-company stocks as a group lost money on average about one out of every three years. That history is a reminder of normal volatility, not a forecast. Investing involves risk, including loss of principal, and past performance does not guarantee future results.

Which kinds of index fund do beginners usually look at?

Broad funds usually come before narrow ones. Here's how the main kinds differ, in general terms:

• Total-market or broad domestic stock funds: many companies of all sizes in one country. Diversified within that market, but tied to one economy.
• Global or international stock funds: companies across many countries. Adds geographic diversification, with currency movements as an extra factor.
• Bond index funds: government or corporate bonds. Generally steadier, and sensitive to interest rates.
• All-in-one or target-date index funds: a pre-set mix of stock and bond index funds in one product, rebalanced for you.
• Sector or theme funds: one industry or idea. Much more concentrated, so a small role at most for a beginner. Real estate (REIT) index funds are a common example; our guide on investing in real estate with little money covers how they work.

Many beginners keep it to one or two broad funds. Two funds that track similar broad indexes will usually behave similarly, so cost and the account you hold them in can matter more than the brand name. Checking the fact sheet's top holdings is a quick way to see how concentrated a fund really is.

Where do you hold index funds in your country?

The same kind of fund can sit in different accounts, and the account decides the tax.

• US: 401(k) plans often include index funds; you can also hold them in an IRA, Roth IRA or taxable brokerage account.
• UK: inside a stocks and shares ISA, a SIPP or a workplace pension.
• Canada: inside a TFSA, RRSP or non-registered account.
• Australia: many super funds offer indexed investment options; outside super, index ETFs trade on the ASX through a broker.

To buy one, you'll need an account. Our guides on how to choose a broker and how to open a brokerage account walk through it.

Next steps

• See how index funds compare with other building blocks in stocks vs ETFs vs bonds.
• Avoid the classic errors in beginner investing mistakes.
• Build the full foundation in our investing for beginners guide.
• Or return to our guide to making money online.