Index funds are a popular investment vehicle designed to follow the performance of a specific market index. Instead of trying to select individual stocks that might outperform the market, an index fund generally holds investments designed to mirror the index it tracks.
What Is an Index Fund?
An index fund is a mutual fund or exchange-traded fund (ETF) that seeks to track the returns of a particular market index.
A market index is essentially a basket of securities—such as stocks or bonds—created to represent a particular market, sector, or segment of the economy. Investors cannot buy an index itself, but they can invest through funds designed to track it.
For example, an index fund may track the S&P 500, giving investors exposure to the companies represented in that index through a single fund.
A Simple Example
Imagine an index contains 100 companies.
Instead of buying shares in all 100 companies separately, an investor could purchase an index fund that tracks that index. The fund then seeks to reproduce the index’s performance.
Market Index → Index Fund → Investor
This makes index funds a convenient way to gain exposure to multiple investments through one fund.
How Do Index Funds Work?
Index funds generally use a passive investment strategy. Rather than having a manager frequently select investments in an attempt to outperform a benchmark, the fund seeks to follow its chosen index.
Some funds purchase all the securities in an index, while others use a representative sample. The exact approach depends on the fund and the index it follows.
What Does an Index Fund Invest In?
The investments depend on the index being tracked.
Some common categories include:
- Large-company stock indexes
- Small-company stock indexes
- Total stock market indexes
- International stock indexes
- Bond indexes
- Sector-specific indexes
- Real estate-related indexes
Some indexes are weighted by market capitalization, meaning companies with larger total market values can represent a larger portion of the index. Other indexes use different weighting methods.
Why Are Index Funds Popular?
1. Diversification
A broad index fund can give investors exposure to many companies or securities through one investment.
Diversification spreads money across different investments rather than relying on a single company or security. However, not every index fund is highly diversified—sector-specific funds, for example, can be relatively concentrated.
2. Simplicity
Instead of researching and purchasing many individual securities, an investor can use a fund designed to track a particular index.
3. Potentially Lower Costs
Because index funds generally use passive management and don’t require the same level of ongoing security selection as many actively managed funds, they may have lower costs. However, not every index fund is inexpensive, so investors should check the actual fees.
4. Less Frequent Trading
Passive funds generally trade less frequently than actively managed funds, although trading activity varies among funds.
Index Funds vs. Actively Managed Funds
| Feature | Index Fund | Actively Managed Fund |
|---|---|---|
| Main goal | Track an index | Pursue a specific investment objective, often with active selection |
| Investment approach | Generally passive | Generally active |
| Trading | Usually less frequent | May be more frequent |
| Diversification | Depends on the index | Depends on the manager’s portfolio |
| Fees | Often lower, but varies | Can be higher, but varies |
| Performance target | Approximately follow its index before fees | May seek to outperform a benchmark |
The differences can vary considerably between individual funds, so investors should examine each fund’s documents and costs rather than relying only on the category.
What Are the Risks of Index Funds?
Index funds can provide diversification, but they still carry investment risk.
Market Risk
If the market or index declines, an index fund tracking that market can also lose value.
Tracking Error
An index fund may not perfectly match the performance of its underlying index. Differences can result from fees, trading costs, sampling methods, and other factors.
Concentration
A fund tracking a narrow sector or a concentrated index may not provide the same diversification as a broad-market fund.
No Guaranteed Returns
Index funds do not guarantee profits. Their performance depends on the investments they hold and the market they track.
What Is an Expense Ratio?
The expense ratio represents the annual operating expenses charged by a fund.
For example, suppose a fund has an expense ratio of 0.20%. As a simple illustration, that equals approximately $2 per year for every $1,000 invested, before considering changes in the investment’s value.
Fees matter because investment expenses reduce returns over time. Investors should compare the actual costs of funds they are considering.
How Can Beginners Research an Index Fund?
Before investing, it can be useful to look at:
- The index being tracked
- The fund’s expense ratio
- The fund’s holdings
- How diversified the portfolio is
- The fund’s tracking performance
- Trading or transaction costs
- The fund’s risks
- Whether the investment fits your financial goals
Investor.gov recommends reviewing a fund’s available information, including its prospectus and shareholder reports, before investing.
Index Funds and Long-Term Investing
Many investors use index funds as part of long-term investment strategies. The idea is generally to gain exposure to a broad market or a particular segment rather than frequently trading individual securities.
However, a long-term approach does not remove market risk. The value of an index fund can rise and fall, sometimes significantly, depending on the market it follows.
Final Thoughts
Index funds offer a way to invest in a collection of securities through a single fund. Their passive structure means they generally aim to follow an existing index rather than having a manager continually select investments.
Their potential advantages include simplicity, diversification, and potentially lower costs, but they are not risk-free. Understanding the index, holdings, fees, and risks is important before investing.
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