Index Funds Explained: What You Own and What It Costs
You are not trying to beat the market. You are trying to own it cheaply and not interrupt it.
At a glance
Figures checked 1 Sep 2026
What to take away
- An index fund holds the securities in a published index in proportion, so returns track the market minus a very small fee.
- Costs compound against you exactly as returns compound for you — a 0.80% fee over 30 years takes a large share of the final balance.
- Diversification removes the risk of any single company failing; it does not remove market risk.
- The hard part is not selection. It is continuing to buy during the years the market falls.
An index fund is a pooled investment that mechanically holds whatever is in a published index. A total US market fund holds thousands of companies weighted by size. Nobody is deciding which ones look promising; the rules of the index decide, and the fund follows.
That sounds like an absence of skill, and it is. It is also why index funds work. Deciding not to guess removes the cost of guessing — research staff, trading, and the manager’s fee — and the evidence from decades of fund performance data is that most active managers do not recover those costs over long periods.
What the fee actually takes
Expense ratios look trivial in isolation. Compounded over a working lifetime they are not.
| Annual fee | Ending balance | Lost to fees |
|---|---|---|
| 0.03% | $606,000 | $3,000 |
| 0.30% | $580,000 | $29,000 |
| 0.80% | $538,000 | $71,000 |
| 1.50% | $487,000 | $122,000 |
Same contributions, same market, four different outcomes. The only variable is what you were charged for access.
Index funds versus index ETFs
Both track indexes. A mutual fund trades once a day at the closing net asset value; an ETF trades through the day like a share. In a tax-advantaged account the choice barely matters. In a taxable account, ETFs are usually slightly more tax-efficient because of how they handle redemptions.
What indexing does not protect you from
- Market declines. A total market fund fell along with everything else in 2008, 2020 and 2022.
- Sequence risk near retirement, when a large fall arrives just as you start withdrawing.
- Your own behaviour, which is the largest risk in the list.
The most expensive thing an index investor does is sell during a fall. The fee is visible and small; the behaviour cost is invisible and large.
A workable starting portfolio
A total US stock market fund, a total international stock fund and a total bond fund cover most of what a long-term investor needs. The weights depend on your horizon and tolerance, not on anyone’s forecast.
Common questions
They are diversified, not safe. Diversification protects against a single company failing. It does not protect against the market as a whole falling, which it does periodically and sometimes sharply.
For a core holding, a total US market or S&P 500 fund. The two behave very similarly because large companies dominate both.
Many brokers allow fractional shares, so effectively a few dollars. Consistency matters far more than the opening amount.