Index Funds 101: How Index Funds and ETFs Work
A plain-English guide to index funds and ETFs: how they work, why fees matter over decades, which index to choose, and tax-advantaged accounts by country.
Index funds are among the most widely recommended ways for ordinary investors to build wealth. Instead of trying to pick winning companies, an index fund simply buys the whole market, or a defined slice of it, and holds it at low cost. This guide explains how they work, why fees matter so much, and how to get started wherever you live.
Key takeaways
- An index fund tracks a market index, such as a broad stock market, by holding the same securities in roughly the same proportions.
- Low costs are the main advantage; a difference of under one percentage point a year can add up to a large sum over decades.
- Broad index funds provide instant diversification across hundreds or thousands of companies.
- Choosing between a total-market, S&P 500 or global fund depends on how widely you want to diversify, especially outside the US.
- Holding index funds inside a tax-advantaged account, which varies by country, can significantly improve after-tax returns.
What is an index fund?
A market index is a rules-based list of securities. The S&P 500, for example, tracks around 500 large US companies, weighted by market value. Other well-known indices include the FTSE 100 in the UK, the S&P/TSX Composite in Canada, the Nifty 50 in India and the S&P/ASX 200 in Australia.
An index fund holds the securities in its chosen index so that its performance closely matches the index, minus a small fee. No manager is trying to beat the market; the fund trades only when the index changes or investors add or withdraw money.
Mutual funds versus ETFs
Index funds come in two main structures:
- Index mutual funds are bought and sold directly with the fund provider or through a platform, usually at a single price calculated at the end of each trading day.
- Exchange-traded funds (ETFs) trade on a stock exchange throughout the day like shares. Most ETFs track an index, although some are actively managed.
Both can be excellent choices, and availability and tax treatment differ by country.
Why fees matter so much
Every fund charges an annual fee, usually expressed as an expense ratio or ongoing charge. A fund with a 0.20% expense ratio costs 20 per year for every 10,000 invested. Broad index funds are typically among the cheapest options, often charging well under 0.25% a year, while actively managed funds commonly charge 0.5% to 1% or more, and in some markets higher still.
Fees are deducted every year from a growing balance, so their impact compounds.
Worked example: the long-run cost of fees
Assume an investor starts with 10,000, adds 500 a month and earns a 7% average annual return before fees. The only thing that changes is the annual fee.
| Annual fee | After 10 years | After 20 years | After 30 years |
|---|---|---|---|
| 0.05% | 106,302 | 298,876 | 683,965 |
| 0.20% | 105,297 | 293,042 | 662,916 |
| 0.50% | 103,323 | 281,775 | 623,007 |
| 1.00% | 100,134 | 264,122 | 562,483 |
After 30 years, the investor paying 1% ends up with roughly 121,000 less than the investor paying 0.05%, despite identical contributions. Real returns vary and are never guaranteed, but the drag from fees is certain.
Diversification: the other big advantage
Owning a single company exposes you to its specific risks, such as poor management or a failed product. A broad index fund spreads your money across hundreds or thousands of businesses, so the failure of any one has a limited effect. Diversification does not remove market risk, since whole markets can fall sharply, but it reduces the risk of permanent loss from a few bad picks.
Total-market, S&P 500 or global?
| Fund type | What it holds | Considerations |
|---|---|---|
| S&P 500 | Around 500 large US companies | Concentrated in large US firms; excludes smaller companies and the rest of the world |
| US total market | Large, mid and small US companies, often several thousand | Broader than the S&P 500, but still a single country |
| Home-country index | Major companies in your own market | Can be concentrated in a few sectors, such as banks and resources in some smaller markets |
| Global or all-world | Developed and often emerging markets combined | Widest diversification; currency movements affect returns |
The S&P 500 and a US total-market fund have historically behaved similarly because large companies dominate both. For investors in Canada, the UK, India and Australia, a global fund, or a mix of home-country and international funds, avoids relying on one economy. Holding extra home-market shares, known as home bias, can bring tax or currency advantages but reduces diversification.
Tax-advantaged accounts by country
Where you hold your funds can matter as much as which funds you choose. Contribution limits and withdrawal rules change over time, so check current rules with your tax authority or a qualified adviser.
United States
Workplace 401(k) plans and Individual Retirement Accounts (IRAs) are the main retirement vehicles. Traditional versions typically offer a tax deduction now and taxable withdrawals later, while Roth versions use after-tax money and offer tax-free qualified withdrawals.
Canada
The Registered Retirement Savings Plan (RRSP) offers a deduction on contributions, with withdrawals taxed as income. The Tax-Free Savings Account (TFSA) offers tax-free growth and withdrawals. The First Home Savings Account (FHSA) combines features of both for eligible first-time buyers.
United Kingdom
A Stocks and Shares ISA shelters growth and withdrawals from tax, subject to an annual allowance. A Self-Invested Personal Pension (SIPP) receives tax relief on contributions but generally cannot be accessed until a minimum pension age.
India
There is no single wrapper for index funds; investors typically buy index mutual funds or ETFs tracking indices such as the Nifty 50 through a mutual fund platform or demat account. The Public Provident Fund (PPF) is a government-backed fixed-income scheme rather than an equity investment, but it is often part of a long-term plan. The National Pension System (NPS) lets members choose an equity allocation. Equity Linked Savings Schemes (ELSS) are equity mutual funds with a three-year lock-in that qualify for a deduction under the old tax regime.
Australia
Superannuation is the main retirement system, funded largely by compulsory employer contributions. Many super funds offer low-cost indexed investment options. Outside super, investors commonly buy index ETFs through a brokerage account.
How to start investing in index funds
- Build an emergency fund first so you are not forced to sell during a downturn.
- Use available tax-advantaged accounts, especially if your employer matches contributions.
- Choose a broad, low-cost fund, such as a global or total-market fund, or a simple mix of a few.
- Decide your stock and bond mix based on your time horizon and how much volatility you can tolerate.
- Automate regular contributions so you invest consistently in rising and falling markets.
- Rebalance occasionally and avoid reacting to headlines.
Common mistakes to avoid
- Assuming every fund labelled "index" is cheap; compare expense ratios.
- Holding several funds that track the same index and believing you are diversified.
- Selling in a panic after a market fall.
- Ignoring currency risk and home bias when choosing between local and global funds.
- Investing money you will need soon.
Watch: a visual explainer
Video by Ben Felix, embedded via YouTube. Private.Finance is not affiliated with the creator.
Frequently asked questions
Are index funds safe?
Index funds are not risk-free; their value rises and falls with the market they track, and broad stock markets have historically experienced large temporary declines. They do, however, avoid the concentrated risk of owning a few individual companies. They are generally best suited to money you can leave invested for many years.
What is a good expense ratio for an index fund?
For a broad stock market index fund, expense ratios are typically well under 0.25% a year, and many large funds charge less than 0.1%. Costs vary by country, fund size and asset class. When two funds track the same index, the cheaper one is usually the better choice.
Should I choose an ETF or an index mutual fund?
Both can be excellent long-term holdings. ETFs are widely available through brokerages, while mutual funds can be simpler for automatic fixed-amount contributions. Compare total costs, including trading or platform fees, and check local tax treatment.
How much money do I need to start?
Many platforms let you start with a small amount, and some allow fractional ETF shares. Starting early with modest, regular contributions usually matters more than waiting for a large lump sum. Check for account fees that could take a big share of a small balance.
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