Investors who are concerned about mutual fund fees and who are convinced that, in an efficient market, the extra costs of an active manager are wasted, prefer to buy indexes directly. Index mutual funds, and more recently a pooled investment called an index share, give them the vehicle to do just that.

Common Types

Index shares are similar to mutual funds in that they are a basket of stocks that give investors the effect of owning a broad number of companies. Unlike mutual funds, which investors purchase by depositing dollars into the fund, index shares are purchased like stocks. Investors trade the shares on the market among other buyers and sellers. Index shares don't have the added costs associated with managing dollar deposits and withdrawals, so their fees and tax costs — they seldom have taxable gains to distribute to shareholders as mutual funds do — are lower.

The American Stock Exchange created the first index share to track the S&P 500 and gave it the symbol SPY. A nickname took root and investors were able to add Spiders to their portfolios. The American Stock Exchange quickly followed Spiders with new indexes tracking other markets. S&P 400 for mid cap U.S. stocks trades under the symbol MDY. New exchange-traded funds (ETFs), as many of the index shares are formally called, are being created almost daily.

Choosing and Comparing ETFs

ETFs are especially useful when you are making a one-time investment, such as from a previous employer's retirement plan into your own IRA. ETFs are sold like stock, so each trade generates a commission for the broker you're using. This commission is usually lower than what you would pay on a front-end loaded mutual fund and is seldom based on the size of the trade. Most frequently, you might see a $10 or $15 commission charged by your online broker for each ETF trade. The per-transaction cost of ETFs makes monthly investing expensive. If you're planning a monthly contribution to an account, no-load mutual funds offered either directly from the fund itself or through your broker as a no-transaction-fee fund is a better choice.

Trends

Many investors build their whole portfolio out of ETFs. A selection of the broad market ETFs just mentioned — SPY, MDY, IWM, and EFA — are a great foundation to a portfolio. Recently, more ETFs have been — and continue to be — created that track particular industry sectors or adhere to investing styles such as small-company value investing. These ETFs are often not large enough to truly mirror the index they're targeting. ETFs need to be mature and sizable to be effective. Stick with the ones that have been around for at least five years and check Morningstar to see how well their performance has tracked their target index. Index shares are passively managed investments; if you want to add specific industry sectors or other specialties to your portfolio, an actively managed mutual fund would be a better choice.