Introduction to Investing: A Beginner's Guide to Asset Classes
The first step is learning to distinguish different types of investments and what rung each occupies on the risk ladder.
index funds
However, most people are too busy to worry about monitoring their portfolios daily. Therefore, sticking with index funds that mirror the market is a viable solution. Steven Goldberg, a principal at the firm Tweddell Goldberg Wealth Management and longtime mutual funds columnist at Kiplinger.com, further argues that most individuals only need three <anchor>index funds</anchor>: one covering the U.S. equity market, another focused on international equities, and the third tracking a broad bond index.
What Are Index Funds, and How Do They Work?
# What Are Index Funds, and How Do They Work?

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Jason Fernando is a professional investor and writer who enjoys tackling and communicating complex business and financial problems.

Updated July 25, 2024

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Reviewed bySamantha Silberstein

Samantha (Sam) Silberstein, CFP®, CSLP®, EA, is an experienced financial consultant. She has a demonstrated history of working in both institutional and retail environments, from broker-dealers to RIAs. She is a current CFA level 3 candidate and also has her FINRA Series 7 and 63 licenses. Throughout her career, Samantha has used her expertise and various licenses and certifications to provide in-depth advice about household and business-specific financial planning, investing, credit cards, debt, student loans, taxes, retirement, and income strategies.

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Part of the Series

Guide to Index Fund Investing

Introduction to Index Funds

Index Fund Examples

Index Fund Risks and Considerations

Definition

An index fund is a type of mutual or exchange-traded fund (ETF) that tracks the performance of a market index, such as the S&P 500, by holding the same stocks or bonds or a representative sample of them.

Index funds are defined as investments that mirror the performance of benchmarks like the S&P 500 by mimicking their makeup. These passive investments, long considered an unimaginative way to invest, are behind a quiet revolution in U.S. equity markets, attracting a widening swath of investors. The numbers tell the story: Passive index funds tracking market benchmarks accounted for just 21% of the U.S. equity fund market in 2012. By 2023, passive index funds had grown to about half of all U.S. fund assets.

Autumn Knutson, founder and lead financial planner at Styled Wealth and an Investopedia top-100 financial advisor, said there are good reasons why. "Index funds are a low-cost way to track a specific group of investments, which can be more broadly diversified than individual stocks and simpler to buy than each of the individual holdings within the index," she said. "They are very popular for people looking to invest in a group of investments in a simple and cost-effective way."

The seismic shift in the rise of passive funds has come as they often convincingly outperform their actively managed peers. According to the widely followed S&P Indices Versus Active (SPIVA) scorecards, about 9 out of 10 actively managed funds didn't match the returns of the S&P 500 benchmark in the past 15 years.

### Key Takeaways

- An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
- Mutual and exchange-traded funds (ETFs) have many different varieties of low-cost index funds focused on some part of the market—or the whole of it.
- They have lower expenses and fees than actively managed funds.
- Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market.

Given this, critics argue that managers of actively traded funds have extracted higher fees for themselves while returning less to clients. Below, we unpack what index funds are and how they work. And we'll discuss the benefits and drawbacks of building a portfolio with index funds.

Investopedia / Madelyn Goodnight

## What Are Index Funds?

Indexes and index funds exist for almost any part of the financial market. Index funds invest in the same assets using the same weights as the target index, typically stocks or bonds. If you're interested in the stocks of an economic sector or the whole market, you can find indexes that aim to gain returns that closely match the benchmark index you want to track. Index funds use a passive investing strategy, trading as little as possible to keep costs low.

For broad indexes like the S&P 500, it would be impractical or expensive to put in the right proportions on your own. Index funds do the work for you by holding a representative sample of the securities. S&P 500 index funds, the most popular and oldest such funds in the U.S., mimic the moves of the stocks in the S&P 500, which covers about 80% of all U.S. equities by market cap.

The portfolios of index funds only change substantially when their benchmark indexes change. If the fund follows a weighted index, its managers may periodically rebalance the weights (the percentage by market cap) and components of their fund's securities to keep matched up with the target index.

Besides the S&P 500, other major indexes followed by such funds include the Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, which follows the total U.S. dollar-denominated bond market; and the Dow Jones Industrial Average, consisting of 30 large-cap companies chosen by the editors of the Wall Street Journal.

Index funds provide broad market exposure and diversification across various sectors and asset classes according to their underlying index. The broader index funds are often quite good at minimizing tracking errors, the difference between the fund's performance and the target index.

However, you'll want to review closely any fund's fees and performance before investing. To give an idea of how close the funds should track their targets, as of July 2024, Fidelity's Nasdaq Composite Index Fund (FNCMX) had a 10-year average annual return of 16.37% versus 16.34% for the Nasdaq composite, a 0.03% difference.

Investing in index funds means putting your money not behind the skills of active fund managers but on the prospects of specific parts of the market.

## Are Index Funds Good Investments?

As Knutson noted, index funds are very popular among investors because they offer a simple, no-fuss way to gain exposure to a broad, diversified portfolio at a low cost for the investor. They are passively managed investments, and for this reason, they often have low expense ratios. In bull markets, these funds can provide attractive returns as the market rises, lifting all boats. They do come with disadvantages, however. One is the lack of downside protection; in prolonged downtrends, these funds can perform poorly in line with the broader market.

For investors considering index funds, there are two main ways to do so:

1. Self-directed research: This involves educating yourself on index fund investing principles, staying informed about market trends and tax implications, and regularly reviewing and adjusting your portfolio.
2. Seeking professional advice: Consulting with a financial advisor can guide you in selecting a fund based on a broad understanding of your portfolio and ensure your choice aligns with your overall financial goals.

Investors in index funds can often benefit from professional guidance, despite index funds' reputation as a do-it-yourself investing solution, "Advisors are able to help with compiling a portfolio of multiple index funds that track multiple markets, say a U.S. large-cap index fund, an international stock index fund, and perhaps a U.S. and International Bond Index Fund," Knutson said.

This diversification strategy can help spread risk across different markets and asset classes. Knutson added that these portfolios should be "monitored for rebalancing (to ensure no portion of those investments get over or underweight)."

The need for professional advice is more readily apparent when your finances are more complex. An advisor can be "especially helpful if the account is taxable or if there are irregular contributions to an account," Knutson said. "Otherwise, there could be tax efficiencies left on the table or the account could get more out of balance than preferred if there are no recurring contributions being put in to keep it rebalanced with each new contribution."

While index funds are, for many, a straightforward investing approach, they're not a one-size-fits-all solution, and thousands of choices are available. The decision to invest in index funds—and how to manage them as part of a wider portfolio—should be based on your financial situation, goals, and risk tolerance. Whether you choose to go it alone or seek professional guidance, understanding the pros and cons of index fund investing is crucial to making informed investment decisions.

## Benefits of Index Funds

The primary advantage index funds have over their actively managed peers is lower fees. So, if actively managed funds don’t outperform their passive peers, more investors are asking, why are we paying fund managers so much more in fees each year? Using SPIVA data as a proxy, which compares the performance of actively managed funds with specific benchmarks, 79% of actively traded funds had underperformed the S&P 500 the previous five years, according to data last published in mid-2024. When you extend that to 15 years, it's 88%.

A greater public understanding of this kind of data helps explain the growing popularity of passive funds, almost all of which are index funds. You still have to pay an expense ratio with these funds, charged as a percentage of the assets under management to pay to advisors and managers and cover transaction fees, taxes, and accounting costs.

Since the managers of index funds are simply replicating the performance of a benchmark index, they don't need research analysts and others to choose stocks, timing trades, etc. They also trade holdings less frequently, meaning fewer transaction fees and commissions. By contrast, actively managed funds have large staffs and conduct trades with more complications and volume, driving up costs.

As such, index funds can charge less than their actively trading peers. They often cost as low as 0.04%—compared with the higher fees that actively managed funds command, typically 0.44% and sometimes higher than 1.00%, depending on the assets.

Let's summarize the advantages:

1. Lower costs: Index funds typically have lower expense ratios because they are passively managed.
2. Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.
3. Transparency: Since they replicate a market index, the holdings of an index fund are well-known and available on almost any investing platform.
4. Historical performance: Over the long term, many index funds have outperformed actively managed funds, especially after accounting for fees and expenses.
5. Tax efficiency: Lower turnover rates in index funds usually result in fewer capital gains distributions, making them more tax-efficient than actively managed funds.

These funds have many virtues that make them well-suited for ordinary long-term investors. That said, the best choice for you—active or passive—depends on your financial goals, the investment environment, risk tolerance, and other specifics about your situation. Over the long term, many have seen the benefits of their comparative returns.

## Drawbacks of Index Funds

Among the critiques of index funds is their inherent lack of flexibility. Because they are designed to mirror a specific market, they decline in value when the market does, and they can't pivot away when the market shifts.

Similarly, they are also criticized for automatically including all the securities in an index. This means they may invest in companies that are overvalued or fundamentally weak, leaving aside greater weighting of assets that could provide better returns. Of course, this automated strategy has often outperformed active management, perhaps in part by holding onto assets that active fund managers have misjudged.

Another disadvantage has to do with what's called market-cap weighting, which many index funds use. Companies with higher market capitalizations have a more significant influence on the fund's performance in such funds. This concentration can lead to being too tied to the fate of a few large companies, magnifying your risks if these companies underperform.

## Best Index Funds

Best Index Funds Fund NameMinimum InvestmentExpense Ratio10-Yr Avg. Annual ReturnVanguard 500 Index Fund Admiral Shares (VFIAX)$3,0000.04%13.11%Fidelity Nasdaq Composite Index Fund (FNCMX)$00.29%16.37%Fidelity 500 Index Fund (FXAIX)$00.015%13.08%Vanguard Total Stock Market Index Fund Admiral (VTSAX)$3,0000.04%12.51%Schwab S&P 500 Index Fund (SWPPX)$00.02%13.08%Schwab Total Stock Market Index Fund (SWTSX)$00.03%12.44%Schwab Fundamental US Large Company Index Fund (SFSNX)$00.25%8.79%USAA Victory Nasdaq-100 Index Fund (URNQX)$2,5000.30%17.78%Fidelity Total Bond Fund (FTBFX)$00.45%2.11%Source: TradingView (as of July 2024)

## Index Mutual Funds vs Index ETFs

If you're interested in index funds, you'll likely have to choose between investing in mutual funds or ETFs that track specific indexes. Both types of funds replicate the performance of a specific market index. However, they differ in several key aspects that can influence which to choose:

- Index mutual funds pool money to buy a portfolio of stocks or bonds. Investors buy shares directly from the mutual fund company at the net asset value ( NAV) price, calculated at the end of each trading day. Among the main advantages of index mutual funds are the simplicity of automatically reinvesting dividends and dollar-cost averaging, the practice of making regular set contributions.
- Index ETFs, meanwhile, are traded on exchanges like individual stocks. This lets investors employ far more trading strategies, like timing ETF share trades, using limit or stop-loss orders, and short selling.

Here's a table comparing the two:

Index Mutual Funds vs. Index ETFsIndex Mutual Funds****Index ETFs****PurposePassively track a specific market index, shares bought/sold from the fund companyPassively track a specific market index, shares traded on an exchangeManagement StylePassivePassivePricingNAV calculated once per day at market closeReal-time market price throughout the trading day, can slightly deviate from NAVTradingBought/sold at the end of the day at NAVBought/sold throughout the day like stocksFeesTypically lower fees than actively managed mutual funds, but often slightly higher than comparable ETFsGenerally low feesTax ImplicationsSince mutual funds must pass on realized capital gains to shareholders, this can create an annual tax liability if gains are realized by the fund manager, though fund managers have ways to minimize thisETFs have a creating/redeeming structure for creation units as they rebalance, so they're not exposed to capital gains that would have to be passed onLiquidityLess liquid than ETFsHighly liquidProsEasy for dollar-cost averaging, automated reinvestment of dividendsIntraday trading flexibility including the ability to put in stop losses or limit orders for managing risk, can be bought in individual shares for price accessibilityConsLimited trading times, minimum investment, potentially higher feesPotential for wider bid-ask spreads during volatility, trading commissions if brokerage charges for tradesExamplesVanguard S&P 500 Index Fund (VFIAX)SPDR S&P 500 ETF (SPY)

## Example of an Index Fund

Index funds have been around since the 1970s but have exploded in popularity over the past decade or so. The fund that started it all, founded by Vanguard chair John Bogle in 1976, remains among the best as judged by its long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully in composition and performance. As of July 2024, Vanguard’s Admiral Shares (VFIAX) had a 10-year average annual return of 13.11% vs. the S&P 500’s 13.14%—a very small tracking error. The expense ratio is low at 0.04%, and its minimum investment is $3,000.

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## How To Invest in Index Funds

Investing in index funds is straightforward for both new and experienced investors. Here’s how to get started investing in index funds:

1. Choose your investment platform: Begin by selecting an online brokerage or investment platform. Some of the best online brokerage platforms provide strong customer support, robust research, and analytical tools.
2. Open and fund an account: Once you’ve chosen a platform, you’ll need to open an account. This typically involves providing personal information, setting up login credentials, and completing a questionnaire about investment goals and risk tolerance. After that, you’ll need to deposit funds. This can usually be done through a bank transfer.
3. Select an index fund: Research different funds to understand their performance history, management fees, and the indexes they track. Consider diversifying your portfolio by investing in several index funds.
4. Buy shares: With your account funded, you can now buy shares of your chosen fund. Most platforms allow you to purchase directly through their website or app with just a few clicks.
5. Monitor and adjust as needed: While index funds are typically long-term investments, it's wise to review your portfolio periodically to ensure it aligns with your financial goals.

## Are Index Funds Better Than Stocks?

Index funds track portfolios composed of many stocks or bonds. As a result, investors benefit from the positive effects of diversification, such as increasing the expected return of the portfolio while minimizing the overall risk. While any individual stock may see its price drop steeply, if it's a relatively small part of a larger index, it won't be as damaging.

## How Much Does It Cost to Invest in an Index Fund?

Many index funds have no minimum required to start investing. Index funds also generally have low annual fees, and these fees, on average, have been declining over the past several years. According to data from the Investment Company Institute in 2024, the average fee for an index fund is 0.05%, with some index funds offering even lower expense ratios. All else being equal, you might wish to choose the lower-cost fund among those that equally track the same index well.

## Are Index Funds Good for Beginners?

Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified. Index funds have lower expense ratios than most actively managed funds, and they often outperform them, too. These reasons make them a solid choice not only for beginners but for many expert investors as well. A final bonus for newer investors: If your fund is tied to a leading index like the S&P 500 or Nasdaq composite, you'll see news coverage often, helping you keep abreast of your investment while learning the broader market's ebbs and flows.

## Are Index Funds Safer Than Stocks?

Index funds are generally safer than individual stocks because of their inherent diversification. They track a specific market index, such as the S&P 500, which means they contain a broad range of stocks across various sectors. If a single company performs poorly, that hurts you if that's a big part of your portfolio. But if it's the S&P 500 index, it's just one of hundreds in your index fund.

## What Are the Best Index Funds for Retirement?

The best index funds for retirement offer growth potential and solid risk management that aligns with your time to retirement and risk tolerance. For long-term growth, consider broad-market equity index funds like the Vanguard Total Stock Market Index Fund (VTSAX) or the Fidelity 500 Index Fund (FXAIX). For diversification and income, bond index funds like the Fidelity Total Bond Fund (FTBFX) can be a good choice. Target-date retirement funds, which automatically adjust their allocation as your retirement approaches, can also be a convenient option for retirement planning, though these are actively managed and invest in a range of indexes and other assets.

## The Bottom Line

Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds. They are designed to replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing, such as retirement accounts.

While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management. Despite these limits, index funds are often favored for their consistent performance and are now a staple in many investment portfolios. Consider your investment objectives and risk tolerance when choosing an index fund. Talking first with a financial advisor for personalized advice is always prudent.

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Part of the Series

Guide to Index Fund Investing

Introduction to Index Funds

Index Fund Examples

Index Fund Risks and Considerations

Take the Next Step to Invest

Advertiser Disclosure

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Related Terms

The profitability index (PI) measures a proposed project's costs and benefits by dividing the projected capital inflow by the investment.

The credit default swap index (CDX) is a financial instrument composed of a set of credit securities issued by North American or emerging market companies.

A lock-up period is a window of time in which investors of a hedge fund or other closely-held investment vehicle are not allowed to redeem or sell shares.

The Russell 1000 Index, a subset of the Russell 3000 Index, represents the 1,000 top companies by market capitalization in the United States.

Direct indexing involves purchasing the underlying shares of an index, rather than owning an index mutual fund or index exchange-traded fund.

The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies

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