What matters when picking an index fund

The index fund you choose depends on three things: which market you want to track, how much you want to pay in fees, and whether you prefer stocks or bonds. You cannot pick the "best" index fund in the abstract — you pick the one that matches your goal and costs the least to own.

If you want U.S. stock market exposure, you have dozens of funds that all track the same index (like the S&P 500) but charge different fees. A fund that costs 0.03% per year will cost you far less over 20 years than one charging 0.50%, even though both track the same index. The fund company, the account type (mutual fund versus exchange-traded fund), and the brokerage where you buy it all affect what you pay.

Start by deciding what you want to own — total U.S. market, international stocks, bonds, or a mix — then compare the actual costs of the funds available to you. The lowest-cost option in each category is usually the right choice.

Key Takeaways

  • Index funds tracking the same index charge different fees, and the difference compounds over decades, so comparing expense ratios is the single most important step.
  • The three main categories are U.S. stock funds, international stock funds, and bond funds; most people use a mix of all three rather than picking one.
  • Exchange-traded funds (ETFs) and mutual funds can track the same index but have different tax and fee structures depending on your account type and brokerage.
  • Your brokerage may offer its own low-cost index funds or may charge transaction fees on certain funds, so the cheapest fund at one brokerage may not be the cheapest at another.

U.S. stock index funds and what they track

A U.S. stock index fund holds shares in American companies. The most common index is the S&P 500, which includes 500 large U.S. companies. Other options include the total U.S. market index (which includes small and mid-size companies too) and the Nasdaq-100 (which leans toward technology companies).

For most people, a total U.S. market fund or an S&P 500 fund is the right choice because it spreads your money across many companies and sectors. The S&P 500 is slightly narrower but still very diversified. Funds tracking the Nasdaq or other narrow indexes concentrate your money in fewer companies or industries, which means higher risk.

The three largest fund companies — Vanguard, Fidelity, and Schwab — each offer low-cost versions of these funds. Vanguard's total U.S. market fund (ticker VTSAX as a mutual fund, VTI as an ETF) has an expense ratio around 0.03%. Fidelity's equivalent (FSKAX or FTIHX) charges the same. Schwab's U.S. Broad Market ETF (SWTSX) also costs 0.03%. All three track slightly different indexes but perform nearly identically over time.

International stock index funds

An international stock fund holds companies based outside the United States. Most people use a developed markets fund (which includes Europe, Japan, Australia, and Canada) rather than an emerging markets fund (which includes China, India, Brazil, and other faster-growing economies). Developed markets funds are less volatile and have lower fees.

Common developed markets indexes include the EAFE (Europe, Australasia, Far East) and the MSCI World ex-USA. Vanguard's developed markets fund (VTIAX or VXUS) costs around 0.05% per year. Fidelity's FSPSX charges the same. These funds hold hundreds of companies across dozens of countries, so a single fund gives you broad international exposure.

Emerging markets funds track indexes like the MSCI Emerging Markets and typically cost 0.08% to 0.10% per year. They are more volatile than developed markets funds but may offer higher long-term returns. Most people who want international exposure use a developed markets fund, emerging markets fund, or a combination of both.

Bond index funds and fixed-income options

A bond index fund holds debt issued by governments or corporations. The most common is the U.S. aggregate bond index, which includes Treasury bonds, corporate bonds, and mortgage-backed securities. These funds pay interest (called a yield) and are less volatile than stock funds, but they also return less over long periods.

Vanguard's total bond market fund (VBTLX or BND) tracks the aggregate bond index and costs 0.03% per year. Fidelity's FXNAX charges the same. Both hold thousands of bonds across many issuers and maturity dates, so your money is spread across many different loans. If you want only U.S. Treasury bonds (the safest option), Vanguard's Treasury fund (VGSLX) costs 0.04% per year.

Bond funds are useful if you want to reduce risk in your portfolio or need income. A common approach is to hold 70% stocks and 30% bonds, or 80% stocks and 20% bonds, depending on your age and how much risk you can tolerate. The older you are, the more bonds you typically hold.

Comparing fees across brokerages and fund types

The same index fund can cost different amounts depending on where you buy it. Some brokerages offer their own low-cost funds and charge transaction fees on competitors' funds. Others charge no transaction fees but may have higher expense ratios on their own funds.

If you have a Vanguard account, Vanguard funds are usually cheapest. If you have a Fidelity account, Fidelity funds are usually cheapest. If you have a Schwab account, Schwab funds are usually cheapest. This is not because one company is better — it is because each company subsidizes its own funds to attract customers. The difference is usually small (0.01% to 0.02% per year), but it compounds over time.

Exchange-traded funds (ETFs) and mutual funds tracking the same index often have the same expense ratio but different tax treatment. In a taxable brokerage account, ETFs are usually more tax-efficient. In a retirement account (401k, IRA), the difference does not matter. Ask your brokerage which funds it offers at the lowest cost in your account type.

Building a simple portfolio from index funds

Most people do not need more than three index funds: one U.S. stock fund, one international stock fund, and one bond fund. A simple portfolio might be 60% U.S. stocks, 20% international stocks, and 20% bonds. Another common mix is 70% U.S. stocks, 15% international stocks, and 15% bonds.

The exact percentages depend on your age, how much risk you can tolerate, and how long until you need the money. A 25-year-old with 40 years until retirement might hold 90% stocks and 10% bonds. A 65-year-old might hold 50% stocks and 50% bonds. There is no single right answer, but the principle is the same: pick your mix, then buy the lowest-cost fund in each category.

Once you have chosen your funds, you do not need to change them. Rebalance once a year by selling funds that have grown too large and buying funds that have shrunk, so you stay close to your target percentages. This takes an hour or less per year and costs nothing at most brokerages.

When to use target-date funds instead

A target-date fund is a single fund that holds a mix of stocks and bonds, automatically shifting toward more bonds as you approach retirement. If you invest in a Vanguard 2050 Target Retirement Fund, the fund company manages the mix for you — you do not have to decide between stocks and bonds or rebalance yourself.

Target-date funds are useful if you do not want to think about asset allocation or if you are uncomfortable picking your own mix. The downside is that they typically cost slightly more (0.08% to 0.15% per year) than building your own portfolio from three low-cost index funds. Over 30 years, that difference adds up to thousands of dollars.

If you choose a target-date fund, pick one from Vanguard, Fidelity, or Schwab — all three offer low-cost versions. Avoid target-date funds from other companies or from your employer's 401k plan unless they cost less than 0.15% per year.

Frequently Asked Questions

Should I pick an ETF or a mutual fund?

In a retirement account (IRA, 401k), it does not matter — they have the same tax treatment. In a taxable brokerage account, ETFs are usually slightly more tax-efficient. Both track the same index and have the same expense ratio, so pick whichever your brokerage makes easiest to buy.

What if my brokerage does not offer the lowest-cost fund?

Compare the expense ratios of the funds your brokerage does offer. The difference between a 0.03% fund and a 0.08% fund is small but real over decades. If your brokerage charges transaction fees on certain funds, factor that in — a $10 fee on a $5,000 purchase costs more than a 0.05% difference in expense ratio.

Can I pick individual stocks instead of index funds?

You can, but research shows that most people who pick individual stocks underperform index funds over time. Index funds spread your money across hundreds of companies, so you do not lose everything if one company fails. If you want to pick individual stocks, keep it to a small portion of your portfolio (10% or less) and use index funds for the rest.

How often should I rebalance my portfolio?

Once a year is standard. Some people rebalance when one fund has grown more than 5% above its target percentage. Rebalancing too often costs money in transaction fees and taxes; rebalancing too rarely means your portfolio drifts away from your target mix and becomes riskier or more conservative than you intended.

Do I need to pick different funds for a 401k versus an IRA?

No. The same principles apply: pick the lowest-cost index funds available in your plan. A 401k often has fewer fund choices than an IRA, so compare what your employer's plan offers and pick the lowest-cost option in each category (U.S. stocks, international stocks, bonds).