Index investing, plainly

What you'll learn: what a stock market index is, how an index fund copies one, and why that simple idea sits underneath everything else in this course.

This course is general education, not financial advice. For decisions about your own money, talk to a qualified adviser.

Meet Maya

Maya is 29, works as a nurse, and has just paid off a car loan. She has an emergency fund in a savings account covering about four months of expenses, a further $6,000 she does not expect to need for many years, and room in her budget to set aside $300 a month. Friends and half the internet keep telling her to "just buy an index fund", and she wants to understand what that means before she does anything.

We will follow Maya through every lesson, from her first question to a plan she can leave running for decades. The numbers are in dollars, but the arithmetic works the same in pounds, euros or any other currency.

What a stock market index is

A stock market index is a list of companies, chosen by a published set of rules, plus a method for combining their share prices into a single number. When a news report says "the market fell 2% today", it is almost always quoting an index.

Some well-known examples:

Most big indexes are market-cap weighted: each company's weight depends on its total market value (share price times the number of shares). A company worth $2 trillion counts for a hundred times more than one worth $20 billion. As companies grow or shrink, their weights move on their own, and the index provider periodically adds companies that now qualify and removes ones that no longer do.

An index on its own is just information. You cannot buy "the S&P 500" any more than you can buy a temperature reading.

The shopping list idea

The easiest way to picture it: an index is like a shopping list. It names every item and how much of each to buy. An index fund is the shopper who buys exactly what is on the list, in the listed amounts, and never improvises.

That shopper does not taste the apples and decide the pears look better. They do not skip an item because a friend said it was overpriced this week. When the list changes, they change the basket to match. That discipline is the whole point: an index fund's job is to match the index, not to beat it.

What an index fund does

An index fund pools money from many investors and uses it to buy the shares in an index, in roughly the same proportions. If Maya puts $300 into a fund that tracks a 500-company index, she ends up owning a tiny slice of all 500 companies, weighted the way the index weights them.

Three things follow from that design:

1. You get the market's return, minus costs. If the index rises 8% in a year, the fund should rise by close to 8%, less its fees and small tracking differences.
2. It is cheap to run. Nobody is paid to research which companies to pick, and the fund trades only when the index changes or money moves in and out.
3. You never beat the market, and you never badly trail it. You give up the chance of picking a star in exchange for never betting everything on the wrong horse.

The alternative is an actively managed fund, where a manager chooses which shares to hold in the hope of doing better than an index. Some managers do, in some years. But active funds usually charge more, and long-running comparisons of fund performance, such as the SPIVA reports published by S&P, have found again and again that most active funds trail their comparable index over ten years or more once fees are taken out. That track record, rather than any belief that markets are perfect, is why index funds became the default suggestion for ordinary savers.

What an index fund is not

A few common misunderstandings are worth clearing up early:

• It is not guaranteed. If the companies in the index fall in value, so does the fund. In a bad year that can mean a fall of a third or more.
• It is not a savings account. There is no fixed interest rate and no promise to give back what you put in.
• "Index fund" is not one product. There are index funds for big companies, small companies, single countries, the whole world, bonds and narrow themes such as one industry. Some of them are not spread out at all.

That last point matters for Maya. "Buy an index fund" is only useful advice once you know which index, and the rest of this course is about making that choice sensibly and then sticking with it.

Where Maya stands

At the end of this lesson Maya writes the first line in a notebook she has started for her plan: "An index fund buys the whole list so I don't have to pick winners." She still has questions. Should she buy an ETF or a mutual fund? How much do fees really matter? Which index, and how much risk is sensible for her? We will take them in that order, and by the last lesson her notebook will hold a complete, written plan.

Recap

• An index is a rule-based list of companies, summarised as a single number.
• Most major indexes weight companies by market value, so big companies count for more.
• An index fund buys what the index lists, so you get the market's return minus costs.
• Active funds try to beat an index; over long periods most have not, once fees are counted.
• Index funds can still fall sharply, and "index fund" covers many very different products.

What you'll learn: how ETFs and mutual funds differ in the way you buy, sell and pay for them, and why the choice matters less than the index and the fee.

Maya's next question

Maya has decided she wants an index fund. She opens her investment platform's search page, types the name of a broad index, and gets two kinds of result: some labelled "ETF" and some labelled "fund" or "mutual fund". Several of them track exactly the same index. She wants to know whether she is choosing between two different investments or two versions of the same one.

The short answer: usually the same investment, sold in two different ways.

The same cereal, a box or a bag

Think of a breakfast cereal sold in a box or a bag. The flakes inside are identical. What differs is the packaging, where you can buy it, and sometimes the price per gram. Choosing between them is a practical decision about how you shop, not a decision about what you eat.

An ETF and a mutual fund that track the same index are like that. Both hold the same shares in the same proportions. The "wrapper" decides how you trade them and what small costs you meet along the way.

How a mutual fund works

A mutual fund (called an OEIC or unit trust in the UK, and often a "managed fund" in Australia) is bought and sold directly through the fund company or through a platform. Its price is worked out once a day, after markets close, from the value of everything it holds. This is called the net asset value, or NAV.

That once-a-day pricing has practical effects:

• You buy in money amounts, such as exactly $300, rather than in whole shares.
• If you place an order at 10am, you get that day's closing price, not the 10am price.
• Automatic monthly investing is usually simple to set up.
• Some funds have a minimum first investment, from nothing at all to a few thousand dollars.

How an ETF works

An ETF, or exchange-traded fund, is a fund whose shares are listed on a stock exchange. You buy and sell them through a broker during trading hours, at whatever the market price is at that moment, just like a company's shares. Specialist firms keep the ETF's market price very close to the value of what it holds.

That brings its own practical effects:

• Prices move all day, so two purchases on the same morning can cost slightly different amounts.
• There is a small bid-ask spread: the price to buy is a little above the price to sell. For large, popular ETFs this is tiny; for obscure ones it can be noticeable.
• Some brokers only let you buy whole shares, which makes investing an exact $300 awkward. Many now offer fractional shares, but not all do.
• Some brokers charge a commission per trade, many charge nothing, and some offer free automatic investing into ETFs.

Side by side

Two details worth knowing

Accumulating or distributing. Companies pay dividends, and a fund has to do something with them. A distributing (or "income") version pays them out to you as cash. An accumulating version reinvests them inside the fund, so the price of each share rises instead. Both are common in the UK and Europe. US funds usually distribute, and platforms let you reinvest automatically. For someone building wealth for decades, reinvesting is usually the point, either way.

Tax and where you live. In the United States, ETFs often pass fewer taxable capital gains on to investors than equivalent mutual funds, because of how ETF shares are created and redeemed. In other countries the tax treatment depends on local rules and on where the fund itself is based. Where you live can also limit what you can buy: for example, many investors in Europe cannot buy US-listed ETFs because of EU disclosure rules, and use European-listed versions instead. Your platform will normally only show you what you are allowed to buy.

What actually matters more

Once two products track the same index, the wrapper usually makes only a small difference to Maya's result over 30 years. What makes a bigger difference is:

1. Which index the product tracks, because that decides what she actually owns.
2. The ongoing fee, because it is charged every year, forever.
3. Whether she can invest automatically, cheaply, every month, because a plan that runs itself is a plan that survives busy weeks.

The day-long trading of an ETF is a feature mainly for people who trade often, and frequent trading is exactly what an index investor is trying to avoid.

Maya's decision

Maya's platform lets her set up an automatic $300 monthly investment into its index mutual funds for free, but charges a small commission on each ETF purchase. For her, the mutual fund version is simpler and cheaper, so she notes in her plan: "Wrapper: mutual fund, automatic on the 1st of the month. Next: compare fees." If she later moves to a broker with free fractional ETF investing, an ETF tracking the same index would do the same job.

Recap

• ETFs and mutual funds tracking the same index hold the same shares; the wrapper differs.
• Mutual funds price once a day and are easy to buy in exact money amounts.
• ETFs trade all day on an exchange, with a small bid-ask spread and sometimes commissions.
• Accumulating versions reinvest dividends; distributing versions pay them out.
• Tax treatment and what you may buy vary by country.
• The index, the fee and automatic investing matter more than the wrapper.