An index fund is a mutual fund or ETF that tries to match the return of a market index, such as the S&P 500, by holding all or a sample of the securities in that index. With no stock picking, they usually trade less and charge lower fees than active funds, but they still fall when their index falls.
You keep hearing that index funds are the simple way to invest, and you want to know what you would actually own before you put money in one. Maybe your 401(k) menu lists a "500 Index" option next to several managed funds, or you are opening your first brokerage account. Either way, the useful questions are the same: what is inside, what does it cost, and what can go wrong.
How does an index fund work?
An index fund copies a published list of securities instead of choosing its own. According to the SEC's investor bulletin on index funds, an index fund is a mutual fund or ETF that "seeks to track the returns of a market index," such as the S&P 500, the Russell 2000 or the Wilshire 5000.
You cannot buy an index directly. The index is just a measurement of a basket of stocks or bonds. The fund buys the securities in the basket so that its performance follows the index, before fees.
Full replication
Some funds hold every security in the index, in the same proportions. This is common for large, liquid indexes like the S&P 500.
Sampling
Other funds hold a representative sample, which is common for bond indexes or very broad indexes with thousands of small holdings. Sampling saves cost but can make the fund drift further from its index.
How are stocks weighted inside an index fund?
Most index funds give bigger companies a bigger share of the fund. In a market-cap-weighted index, each company's weight depends on its share price times its shares outstanding, so the largest companies drive most of the result. A few indexes, such as the Dow Jones Industrial Average, are price-weighted instead, so a stock with a higher share price counts for more regardless of company size.
This matters because a "broad" index fund can still be concentrated. If a handful of very large companies make up a big slice of the index, they make up the same slice of your fund. It also means you inherit the index's valuation: when the biggest companies are priced at high multiples of their earnings, so is your fund (our guide to the P/E ratio explains how to read that).
Why do index funds usually cost less?
Index funds skip the stock-picking team, so their running costs are often lower. The SEC notes that index managers "are not actively picking securities," so they do not need research analysts to select holdings. Less trading also tends to mean lower transaction costs and fewer taxable capital gains passed to shareholders in taxable accounts.
Not every index fund is cheap, though. Two funds tracking the same index can charge very different expense ratios, so compare before buying.
How much do fees matter? A worked example
Small percentage differences become large dollar differences over time. The SEC's bulletin on fees and expenses shows a $100,000 investment growing 4% a year for 20 years:
| Annual fee | Approximate value after 20 years |
|---|---|
| 0.25% | $208,000 |
| 0.50% | $198,000 |
| 1.00% | $179,000 |
The gap between the cheapest and most expensive case is about $29,000 on the same underlying growth. That is the core argument for paying attention to costs, whatever kind of fund you choose.
Index funds vs actively managed funds: what is the difference?
The difference is the goal: an index fund tries to match a market, while an active fund tries to beat it.
| Index fund | Actively managed fund | |
|---|---|---|
| Goal | Match an index before fees | Beat an index or reach a stated objective |
| Who picks holdings | The index provider's rules | A portfolio manager and analysts |
| Trading | Usually low | Often higher |
| Typical cost | Often lower | Often higher |
| Flexibility in a downturn | Little: it holds what the index holds | Manager can shift holdings |
Neither type removes market risk. An active manager can sidestep some losses or add to them, and you pay for that judgment either way.
What are the risks of index funds?
An index fund carries the risks of whatever its index holds, plus a few of its own. The SEC lists three to know:
Market risk with no exit
If the index drops 20%, the fund drops about 20%. An index fund will not move to cash or change strategy to avoid a decline.
Tracking error
The fund may not follow its index exactly, especially if it uses sampling or holds cash for redemptions.
Underperformance after costs
Fees, trading costs and tracking error mean an index fund typically returns slightly less than its index.
There is also a newer category to watch. Some funds called "index" funds track custom-built or "smart beta" indexes that follow a strategy rather than a broad market. They can behave very differently from a plain market index fund, so read what the index actually measures.
How do you choose an index fund?
Start with the index, then compare funds that track it. A short checklist:
- Which index? Large U.S. stocks, the total U.S. market, international stocks and bonds all behave differently. Pick based on the role it plays in your overall mix of investments, not on last year's return.
- What is the expense ratio? Find it in the fee table near the front of the prospectus.
- How closely has it tracked? Compare the fund's returns with its index over several years.
- Mutual fund or ETF? ETFs trade during the day like stocks; mutual funds price once a day. Minimums and account access differ.
- Who is the fund company? Confirm it is registered and read the most recent shareholder report on the fund's site or on EDGAR.
If an adviser recommends a particular fund, ask what it costs compared with similar index funds and how the adviser is paid. Our guide on what a fiduciary financial advisor is explains the standard they are held to.
Frequently asked questions
Can you lose money in an index fund?
Yes. An index fund falls when the securities in its index fall, and there is no guarantee the market will recover within your time frame. Spreading money across many companies reduces the risk of one company failing, but not the risk of the whole market declining.
Is an S&P 500 fund the same as a total market fund?
No. An S&P 500 fund holds about 500 large U.S. companies, while a total market fund also holds mid-size and small companies. Because large companies dominate both by weight, their returns are often similar but not identical.
Are index funds the same as ETFs?
Not exactly. An index fund can be a mutual fund or an ETF, and some ETFs are actively managed rather than tied to an index. "Index" describes the strategy; "ETF" or "mutual fund" describes the structure.
How often do index funds change their holdings?
They change when the index changes, usually at scheduled rebalancing dates or when companies are added or removed. That is why turnover is generally lower than in actively managed funds.
Related: What is the P/E ratio and how do you use it? · What is liquidity risk? · How to choose a financial advisor