Index funds and ETFs: buy the whole haystack

Picking individual stocks means betting that you can spot the winners, and that the winners are not already priced in. An index fund takes the opposite approach: instead of searching for the needle, it buys the whole haystack.

What an index fund is

An index is a list of securities that represents a slice of the market. The S&P 500 tracks about 500 large U.S. companies; total-market indexes track thousands; others cover international stocks or bonds. An index fund simply buys what is on that list, in the same proportions, and holds it. No star manager, no hunches, no forecasts.

The result is instant diversification. With a single purchase of an S&P 500 index fund, you own a small slice of hundreds of companies across every major industry. If one company collapses, it is a ripple, not a shipwreck.

John Bogle's Vanguard launched one of the first index funds for everyday investors in the mid-1970s, and critics mocked it at the time. Today index funds hold trillions of dollars.

Two wrappers: mutual funds and ETFs

• A mutual fund is bought and sold through the fund company or a broker once a day, at the closing price. Some have minimum investments.
• An ETF, or exchange-traded fund, trades on an exchange like a stock, all day long, at the current market price. Many brokers let you buy fractional shares.

Both can hold the same investments. ETFs are often somewhat more tax-efficient in a regular taxable account, while mutual funds make automatic monthly investing simple. And "ETF" does not automatically mean "index fund," so always check what a fund actually holds.

The quiet killer: fees

Every fund charges an annual fee called the expense ratio, deducted automatically from your returns. It looks tiny, but it compounds. Take $10,000 growing 7% a year before fees for 30 years:

One percentage point of fees consumed roughly a quarter of the final balance. Broad index funds are among the cheapest funds available, and many charge well under 0.20% a year. Test your own funds in the fee-drag calculator.

Passive versus active

Active investing means trying to beat the market by picking stocks or timing trades. Passive investing means accepting the market's return, minus a small fee. Active sounds smarter, but the evidence is humbling. S&P Dow Jones Indices publishes a long-running report called SPIVA that compares active funds with their benchmarks, and year after year it has found that most actively managed U.S. stock funds trail their benchmark over long periods such as 10 or 15 years.

The reason is mostly arithmetic. Before costs, investors as a group earn the market's return. After costs, the average actively managed dollar must earn less than the average passive dollar, because it pays more in fees and trading. Some active managers do win, but picking them in advance has proven very hard.

What to look for

• What it tracks: a broad index, or a narrow theme?
• Expense ratio: lower is better, all else equal.
• Size and trading volume: larger, heavily traded funds usually have tighter spreads.
• Concentration: in an index weighted by market value, the biggest companies carry the most weight, so a handful of giants can drive much of the result.

Index funds will not make you rich quickly. They are built to deliver the market's return, reliably and cheaply, for as long as you hold them. As the compounding lesson showed, that patience is exactly what time needs to work.