How Index Funds Work and Why Investors Use Them
An index fund tracks a list of stocks or bonds instead of trying to beat the market
An index fund is a fund that holds the same stocks or bonds as a published list — called an index — and moves up or down with that list. The S&P 500 index, for example, tracks 500 large U.S. companies. An S&P 500 index fund holds those same 500 companies in the same proportions, so when the index goes up 5%, the fund goes up roughly 5% too.
The fund manager does not pick which stocks to buy or sell based on research or predictions. Instead, they simply own what the index owns. This is called passive management. Because the manager is not paying analysts to research companies or trading constantly, index funds charge lower fees than actively managed funds that try to beat the market.
Index funds exist for almost every market segment: U.S. large companies, U.S. small companies, international stocks, bonds, real estate, and combinations of all three. You can buy an index fund through a brokerage account, a 401(k), or an IRA.
Key Takeaways
- An index fund holds the exact stocks or bonds in a published index, so its returns match the index's returns minus a small fee.
- Because index funds do not require active stock-picking, they charge lower fees than actively managed funds.
- Index funds are available for U.S. stocks, international stocks, bonds, real estate, and blended portfolios.
- You own all the companies in the index at once, which spreads your risk across many holdings instead of betting on a few picks.
How an index fund differs from an actively managed fund
An actively managed fund pays a manager and research team to choose which stocks to buy and sell, trying to earn returns higher than the market average. That research and trading costs money. The fund's expense ratio — the annual fee you pay — typically runs 0.5% to 1.5% or higher of your investment each year.
An index fund buys and holds the index. The manager's job is to match the index as closely as possible, not to beat it. Because there is far less trading and no research team, the expense ratio is usually 0.03% to 0.20% per year. Over decades, that difference in fees adds up. A 1% annual fee costs you roughly one-quarter of your long-term returns; a 0.10% fee costs you almost nothing.
Neither approach is right for everyone. Some investors believe skilled managers can beat the market enough to justify higher fees. Others believe the historical data shows most managers do not, and that lower fees make index funds the better choice for most people.
What you own when you buy an index fund
When you buy shares of an S&P 500 index fund, you own a tiny piece of all 500 companies in that index. If the index fund holds 1,000 shares of Apple and you own 0.01% of the fund, you own 0.1 shares of Apple (though you cannot sell just that piece — you sell shares of the fund itself).
This automatic diversification is one reason index funds appeal to beginners. You cannot accidentally put all your money in one company. You own Microsoft, Coca-Cola, Tesla, JPMorgan, and 496 others in one purchase. If one company's stock drops 20%, it affects your fund by a fraction of a percent.
Different indexes own different things. A total U.S. stock market index owns thousands of companies of all sizes. A bond index might own government and corporate debt. A real estate index owns shares in real estate investment trusts. You choose which index matches what you want to own.
Index funds versus ETFs that track indexes
Many index funds are also exchange-traded funds (ETFs). An ETF is a fund that trades on a stock exchange like a stock does — you can buy and sell it during market hours at a price that changes throughout the day. A traditional mutual fund index fund trades only once per day, after the market closes, at a price calculated at the end of the day.
For most individual investors, this difference does not matter much. Both hold the same index, charge similar fees, and produce similar returns. ETFs are slightly more tax-efficient in some situations and easier to trade in and out of quickly. Mutual funds are simpler if you are buying and holding for years without trading.
Many brokerages now offer commission-free trading on both ETFs and mutual funds, so the old advantage of ETFs being cheaper to buy is gone. The choice between them usually comes down to personal preference and which one your brokerage makes easiest to use.
How index funds fit into a portfolio
Many investors build a portfolio around index funds because they cover broad market segments cheaply. A simple three-fund portfolio might hold a U.S. stock index fund, an international stock index fund, and a bond index fund. You decide what percentage of your money goes into each one based on your age, risk tolerance, and time horizon.
Some investors use index funds as the core of their portfolio and add actively managed funds or individual stocks around the edges. Others use index funds exclusively. There is no single right answer — it depends on how much time you want to spend researching investments and how much you believe in active management.
Index funds also work well inside retirement accounts like 401(k)s and IRAs, where you cannot trade frequently anyway. The low fees mean more of your money stays invested and compounds over time instead of going to fund managers and brokers.
Costs and fees to understand
The main cost of owning an index fund is the expense ratio, expressed as a percentage of your investment per year. A fund with a 0.10% expense ratio costs you $10 per year on a $10,000 investment. A 1% expense ratio costs $100 per year on the same amount. Over 30 years, that difference is substantial.
Some index funds also charge a transaction fee when you buy or sell, though many brokerages have eliminated these. Check your brokerage's fee schedule before you buy. Some index funds have minimum investment amounts — often $1,000 to $3,000 — though many brokerages now allow you to buy fractional shares with no minimum.
You may also owe capital gains taxes when you sell an index fund at a profit, though index funds tend to generate fewer taxable gains than actively managed funds because they trade less frequently. In a tax-advantaged account like an IRA or 401(k), you do not owe taxes until you withdraw the money.
When index funds might not be the right choice
Index funds work best for long-term investors who can hold through market ups and downs without selling. If you need the money in the next few years, the risk that the market drops before you need it is real, and an index fund does not protect you from that.
Index funds also assume you want to own what the index owns. If you believe certain industries or companies are overvalued, or if you want to avoid owning companies in specific sectors, an index fund forces you to own them anyway. Some investors prefer the control of picking individual stocks or the flexibility of an actively managed fund.
Index funds are also not a substitute for having an emergency fund or paying off high-interest debt. If you have credit card debt at 18% interest, that is a may provide loss that no investment return can offset.
Frequently Asked Questions
Can I lose money in an index fund?
Yes. If the index drops 20%, your fund drops roughly 20% too. Index funds do not protect you from market declines. They are designed for investors who can hold through downturns and wait for recovery, which historically takes months to years.
Do I get dividends from an index fund?
Yes, if the companies in the index pay dividends. The fund collects those dividends and either pays them out to you or reinvests them automatically, depending on which option you choose. You can usually change this setting in your account.
What is the difference between an index fund and a target-date fund?
A target-date fund automatically adjusts its mix of stocks and bonds as you get closer to retirement, becoming more conservative over time. An index fund holds the same index forever unless you change it. Target-date funds are simpler for hands-off investors; index funds give you more control.
How often should I check my index fund?
Once or twice a year is enough if you are holding long-term. Checking daily or weekly often leads to panic selling during downturns. Index funds work best when you set them and leave them alone.
Can I buy index funds through my 401(k)?
Most 401(k) plans offer at least a few index fund options. Check your plan's investment menu to see what is available. Many financial advisors recommend using index funds as the core of a 401(k) because the fees are low and the long time horizon suits them well.