What is an index fund and how does it work?
Updated: September 17, 2024
Investing in the stock market can be lucrative, but it can also take a lot of work unless you consider an index fund for your investments. It can be an excellent way to passively invest while reducing your risk and building long-term gains.
But before you can invest, there is first one major question to answer: what is an index fund and how does it work? Understanding the basic principles of an index fund can help you make more informed decisions when investing for your financial future.
What is an index fund?
An index fund tracks and imitates the performance of a market index, or market benchmark, in a particular stock market or economic sector. The market index reports on the performance of various securities, such as stocks and bonds, and then the index fund tracks that performance.
Some popular market indexes include the S&P 500 Index, as well as the Nasdaq Composite Index® and Russell 2000 Index.
While you cannot invest in a market index, you can invest in the index fund via a mutual fund or an exchange-traded fund (ETF). Occasionally, index funds may include derivatives, such as options or futures.
Index funds pros and cons
There are both advantages and disadvantages to an index fund.
An index fund is easier for investors to track because it’s based on a market index that can easily be followed on any investor app or platform. They generally perform better1 than actively managed funds, too.
Index funds are typically more affordable than other types of investments because you share the cost of the investment with other investors. Index funds can be more favorable2 for taxes, too, since there are not as many capital gains distributions. With index funds requiring less management, they typically boast lower expense ratios, as well.
That does not mean an index fund is perfect. It requires trust, as you are not able to pick the exact stocks and bonds yourself. Additionally, index funds have historically performed lower than individual investments because they commingle both high- and low-performing securities. Because of this, an index fund requires a long-term approach, so it is not ideal for short-term investing.
Pros
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Lower risk through diversification
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Based on historical performance
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Easily accessible through trading platforms
Cons
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Not always the most lucrative option
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Cannot choose investments
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Investment minimums may apply
Examples of index funds
There are six main types of index funds available for investment.
- Broad market index funds: These funds often represent the majority or even the entirety of an entire sector of stocks, bonds or other securities. An example is the Vanguard Total Stock Market ETF (VTI).
- Market cap index funds: Market cap index funds trade based on a specific market capitalization range. While small-cap funds generally focus on companies with market caps below $2 billion, large-cap funds tend to select companies with market caps of over $10 billion.
- Equal weight index funds: To minimize risk, equal weight index funds maintain holds that are roughly all the same percentage, so no investment is heavily weighted over another. An example includes Invesco S&P 500 Equal Weight ETF (RSP).
- Sector index funds: These index funds focus on a particular sector, such as healthcare or commodities. Examples include Fidelity MSCI Financials Index ETF (FNCL) for financial businesses and Vanguard Communication Services Index Fund (VOX) for communications and media companies.
- Bond index funds: As the name suggests, this type of index fund specializes in bond indexes. Popular examples include the iShares Emerging Market Bond Index (EMBI), Vanguard Total Bond Market ETF (BND) and Fidelity U.S. Bond Index Fund (FXNAX).
- International index funds: These funds track market performance for investments outside the US. Although they are global funds, they can still be accessed via an American brokerage, such as Fidelity or Vanguard.
4 popular index funds compared
Before you can invest, you have to choose the right index fund. So, what is an index fund that is worthy of your investment?
Here we compare some of the most popular index funds available today. This includes popular favorites, such as iShares Core S&P 500 ETF, one of the best S&P 500 ETFs, and Vanguard S&P 500 Growth ETF, one of the best Vanguard ETFs. The index funds included below are particularly notable for their low expense ratio, competitive minimum investment and profitable 10-year average return.
| Fund name | Fund symbol | Minimum investment | Expense ratio | 10-year average return | 5-year average return |
|---|---|---|---|---|---|
| Fidelity 500 Index | FXAIX | None | 0.015% | 12.85% | 15.03% |
| Fidelity ZERO Large Cap Index | FNILX | None | 0.00% | N/A | 15.07% |
| iShares Core S&P 500 ETF | IVV | None | 0.03% | 12.82% | 15.01% |
| Vanguard S&P 500 Growth ETF | VOOG | $1.00 | 0.10% | 16.18% | 14.81% |
How do index funds work?
The index fund is overseen by a professional manager, who uses money from multiple investors to invest in all or some securities within a particular sector. Investments are weighted within the index and are typically based on a company’s market capitalization, or market cap, which shows the overall value of shares. This is calculated by multiplying the share price by the number of outstanding shares. The higher the market cap, the higher the index value will be.
The goal is to receive gains based on the chosen benchmark index, but it’s a type of passive investing, taking a long-term approach and requiring fewer trades than other types of investments. Because you’re buying multiple stocks in an index fund, you stand to receive greater gains than investing in individual stocks on your own. With investments pooled, the cost per share is more affordable than a full share of a particular stock or bond.
By diversifying your portfolio, you can lower your risk of major losses should an investment underperform. This can pay off for investors; the S&P 500 index has produced an average return3 of over 10% annually since its inception in 1957.
How to invest in index funds
Once you have picked the right index, it's time to make your investment.
1. Open an account
You will need to open a brokerage account in order to buy an index fund. Popular accounts come from providers like Acorns, tastytrade and Interactive Brokers. You can also open an account with a company like Vanguard or Fidelity Investments directly if you plan on buying one of its index funds. Be sure to check account costs so you don’t get stuck paying high transaction fees.
2. Choose your fund
Next, you will need to determine the index fund for your investment. An index such as the S&P 500 can help guide you so you find the fund that is right for you. It is important to check that the fund closely tracks the index performance and has low fees so as not to interfere with your earnings. Check for any minimum investments or other restrictions that may be an issue. Other details like company size, sector and location can also help guide your investment.
3. Buy shares
You may choose to invest in a single index fund or multiple ones. Some brokerages allow for purchases of fractional shares, making it even easier to diversify your holdings. Purchases may be made either using a fixed dollar amount or number of shares, depending on your brokerage. Be sure to track your fund over time to see how it is performing compared to the overall index.
If you’re an active investor or options trader looking for a way to save money on trades, you may want to check out discount broker tastytrade. The online service has some of the lowest prices around.
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Interactive Brokers offers low trading fees and robust trading tools — major assets to day traders and other DIY investors. Lower-volume traders will also appreciate that they can access commission-free trading through the IBKR Lite plan.
Who determines the price of index funds?
The price of an index fund4 is largely determined by its net asset value (NAV)5, which is the total worth of all its securities. To find the NAV, the fund’s liabilities are subtracted from its assets and then divided by the number of outstanding shares.
There are other factors that determine the price of index funds. Its expense ratio shows the total maintenance costs of the fund that are deducted from every dollar invested. There is also the tax ratio, which accounts for the amount of taxes you will owe on any capital gains or distributions associated with the fund.
Together, these three factors help determine the price you actually pay for your index fund.
Why invest in index funds?
Index funds are a great way to invest when you do not want to take an active role in the selection and maintenance of your holdings. They allow for greater diversification so your investment is spread across multiple securities, lowering your risk and providing more stable long-term gains.
If you want a hands-off approach to investing, an index fund could be the right fit for you.
Index fund risks
No investment is foolproof, so it is critical to approach investments with caution. Even though index funds are relatively low risk6, they still are not risk-free. Economic changes can easily impact your portfolio, depending on which sectors you choose. You cannot choose your holdings, either, so you are at the mercy of the fund manager.
That’s why it’s so essential that you do your research so you can select the fund manager who will make the best decisions for your investment.
Index funds vs ETFs
When comparing index funds versus ETFs, there are a few fundamental differences.
While both are passive forms of investing, it’s possible to take a more active role with ETF trading, giving you more flexibility in how you invest. Most index funds require a minimum investment, while ETFs typically don’t have minimum requirements. You are also usually limited in when you can trade; while ETFs can be traded at any time of the day or night, index funds are generally limited to business hours.
This is a quick overview of index funds vs ETFs.
| Details | Index funds | ETFs |
|---|---|---|
| Management style | Passive | Passive or active |
| Fees | Lower | Low |
| Trading hours | Limited | 24/7 |
| Minimum investment | Typically applies | None |
Index funds vs mutual funds
Mutual funds are frequently associated with index funds because they have a lot of similarities but there are some key differences.
When comparing index funds vs mutual funds, it’s important to first understand how a mutual fund works. While index funds are more rooted in strategy and track a market index, mutual funds use money from multiple investors to buy and sell securities. Shares of that mutual fund are then sold to other investors. Index funds, on the other hand, invest in shares of companies.
There are four types of mutual funds: money market, fixed-income, equity and target-date funds. Some mutual funds can even be an index fund, and, like index funds, they are actively managed by a fund manager. However, index funds track a market index so they don’t need the constant oversight that mutual funds require. This also makes them more affordable as they don’t bear the costs of professional management.
| Details | Index funds | Mutual funds |
|---|---|---|
| Risk | Lower | Low |
| Management style | Passive | Active |
| Fees | Low | High |
| Diversification | High | High |
FAQs
Lena Muhtadi Borrelli brings over 20 years of experience in the finance industry. She began her career at Morgan Stanley before transitioning over to media. As a finance writer, she has served as an authority for several respected outlets, including Forbes, TIME, Newsweek, Bankrate, Investopedia, Insurance.com, and InvestorPlace. No matter what she is writing, Lena has a unique ability to simplify complex topics, making finance more approachable and relatable to the average reader. When she is not writing or scanning the news for the latest headlines, she is happiest spending time in the Florida sunshine with her husband and two pups.
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