Index Funds and ETFs: A Plain-English Guide for Beginners

For many people, a low-cost index fund is the simplest way to start investing. Instead of trying to pick individual winners, an index fund aims to match the performance of a market index by holding the securities in it. Exchange-traded funds (ETFs) and mutual funds both offer index versions, with some practical differences.

This guide explains how these funds work, using the SEC’s investor education site as the main source. We do not recommend any fund or provider, and nothing here is investment advice.

What a mutual fund and an ETF are

According to Investor.gov, a mutual fund pools money from many investors and invests it in securities such as stocks and bonds. An ETF is also a pooled investment, but its shares trade on an exchange throughout the day, like a stock. Mutual fund shares are generally bought and sold at the price calculated at the end of the trading day. The SEC’s page on mutual funds and ETFs explains the differences in detail.

What makes a fund an index fund

An index fund tries to track a market index, such as a broad stock index or a bond index, rather than having managers choose investments. Investor.gov’s index funds page explains that because they follow an index, they are often described as passively managed and may have lower costs than actively managed funds. They still carry market risk: if the index falls, the fund falls.

Why diversification matters

A single fund that holds hundreds or thousands of securities spreads your money across many companies. That reduces the impact of any one company doing badly. Diversification does not prevent losses in a falling market, but it reduces the risk of a single failure wiping out your investment.

Why costs matter

Every fund charges ongoing expenses, shown as an expense ratio. The SEC’s investor bulletin on fees shows that a $100,000 portfolio growing 4% a year would be worth about $208,000 after 20 years with a 0.25% annual fee, but about $179,000 with a 1.00% fee (source). Low costs are one of the main reasons index funds are popular.

Other costs to check:

Sales loads on some mutual funds.
Trading costs and spreads on ETFs.
Account or platform fees charged by your broker.

Questions to ask before buying

What index does it track? Broad market, a sector, a region, bonds?
What is the expense ratio? Compare similar funds.
How closely does it track the index? Look at “tracking difference” in fund documents.
How large and liquid is it? Very small funds can close.
What is your time horizon? Stock funds can fall sharply in the short term.
Read the prospectus, which explains objectives, risks and costs.

Common beginner mistakes

Chasing last year’s winner. A fund that rose sharply last year may be concentrated in one sector. Past performance does not guarantee future results.
Owning many funds that hold the same thing. Several broad stock funds can overlap heavily; check the top holdings.
Ignoring costs. A narrow or specialist ETF can charge much more than a broad index fund.
Selling in a panic. Markets fall from time to time. Selling after a fall locks in the loss.
Investing money you will need soon. Money for the next few years is usually better kept in savings.
Not checking the account type. Retirement and taxable accounts have different rules; check them before you invest.

Building a simple plan

Decide on a mix of stocks and bonds that matches your time horizon and comfort with risk.
Invest regularly, for example monthly, rather than trying to time the market.
Rebalance occasionally to keep your target mix.
Keep an emergency fund in cash so you are not forced to sell during a downturn.
Review your plan once a year or after major life changes.

Learn about index funds on Investor.gov

Official SEC investor education site. We are not a fund provider or broker.

Where to buy

Index funds and ETFs are available through brokers, fund companies, workplace retirement plans and robo-advisers. Before opening an account, check the firm on FINRA BrokerCheck and read its Form CRS.

Frequently asked questions

Are index funds safe?

They are diversified but still lose value when markets fall. They are not insured like bank deposits.

ETF or mutual fund?

Both can be index funds. ETFs trade during the day; mutual funds trade at the end-of-day price. Costs and account options may differ.

How much do I need to start?

Minimums vary. Some brokers allow small amounts or fractional shares.

Do index funds pay dividends?

Many stock index funds pass on dividends from the companies they hold.

Sources

Related guides

Opportuly Careers is an independent guide. We are not a fund provider, broker or investment adviser and this article is general information, not investment advice. Investing involves risk, including loss of principal.