Index funds are frequently discussed in conversations about long-term investing, diversification and passive investing. They can sound complicated at first but the basic concept is relatively straightforward.
An index fund is designed to track the performance of a specific market index rather than trying to select individual investments that a manager believes will outperform the market.
Index funds can be structured as mutual funds or exchange-traded funds, commonly called ETFs. They can hold many different securities, although the exact holdings depend on the index and the fund's strategy.
In This Guide
- What Is an Index Fund?
- What Is a Market Index?
- How Do Index Funds Work?
- What Is Passive Investing?
- Types of Index Funds
- Index Funds vs. ETFs
- Index Mutual Funds
- Potential Benefits of Index Funds
- Risks and Limitations
- Understanding Index Fund Costs
- Index Funds and Diversification
- How to Compare Index Funds
- Common Beginner Mistakes
- Index Fund Checklist
- Frequently Asked Questions
What Is an Index Fund?
An index fund is a mutual fund or ETF designed to follow a particular market index.
Instead of having a manager make frequent decisions about which individual securities to buy and sell in an attempt to beat the market, an index fund generally seeks to track the securities and weighting methodology of its chosen index.
For example, a fund could be designed to track an index representing a broad group of large companies. Another fund could track bonds, international companies, a particular sector, or another defined market segment.
The important point is that not all index funds are the same. The index being tracked determines what the fund is designed to hold.
What Is a Market Index?
A market index is a measurement designed to represent the performance of a particular group of investments.
An index may represent:
- Large companies
- Small companies
- International companies
- Government bonds
- Corporate bonds
- A specific industry or sector
- A broad market
Indexes can use different methods to determine which securities are included and how much weight each security receives.
How Do Index Funds Work?
An index fund begins with a target index.
The fund then builds a portfolio intended to track that index. Depending on the fund, it may hold all of the securities in the index or use a sampling approach.
The fund's performance will generally move in a similar direction to its target index, although the fund's return can differ from the index because of expenses, trading costs, portfolio differences, taxes and other factors.
A Simple Example
Imagine an index contains 500 companies.
An index fund designed to track that index would seek exposure to those companies according to the index's methodology.
If the index rises or falls, the fund would generally be expected to move in a similar direction, minus the effects of expenses and tracking differences.
What Is Passive Investing?
Passive investing generally means following a predetermined investment strategy rather than frequently selecting securities based on attempts to outperform the market.
Index funds are commonly associated with passive investing because they generally seek to track an index.
Passive does not mean that nothing happens inside the fund. Holdings may change when the underlying index changes and the fund may need to rebalance or otherwise manage its portfolio.
Index Investing vs. Active Investing
Active funds generally use managers or teams who select investments with the goal of achieving a particular objective, which may include outperforming a benchmark.
Index funds generally focus on tracking a predetermined index.
| Feature | Index Approach | Active Approach |
|---|---|---|
| Primary objective | Generally track a selected index | Manager selects investments according to a strategy |
| Trading activity | Generally based on index changes and fund management | Can involve more frequent portfolio decisions |
| Costs | May be relatively low but varies by fund | Can vary widely and may be higher |
| Performance target | Track the selected index | May seek to outperform a benchmark or meet another goal |
This comparison is simplified. Funds differ substantially, so investors should review each fund's documents and strategy.
Types of Index Funds
Index funds can be categorized according to the market segment they track.
Broad Market Index Funds
These funds are designed to provide exposure to a broad group of securities within a particular market.
Large-Cap Index Funds
These funds generally track indexes focused on larger companies.
Small-Cap Index Funds
These funds generally focus on smaller publicly traded companies. Small-company investments can have different risk and return characteristics from large-company investments.
International Index Funds
These funds provide exposure to companies or other securities outside a particular domestic market.
Bond Index Funds
Bond index funds track indexes made up of bonds or other fixed-income securities.
Sector Index Funds
Sector funds focus on a particular part of the economy, such as technology, healthcare, financial services or energy.
Because they focus on a narrower segment, sector funds may be less diversified than broad-market funds.
Index Funds vs. ETFs: What's the Difference?
The terms "index fund" and "ETF" describe different aspects of an investment product.
An index fund describes the investment strategy: the fund seeks to track an index.
An ETF describes the fund structure: shares of the fund trade on an exchange during the trading day.
Therefore, an ETF can be an index fund but not every ETF is an index fund. Some ETFs use active strategies.
| Term | What It Describes |
|---|---|
| Index fund | A fund designed to track a particular index |
| ETF | A fund structure whose shares trade on an exchange |
| Index ETF | An ETF designed to track an index |
| Active ETF | An ETF managed according to an active strategy rather than simply tracking an index |
What Is an Index Mutual Fund?
An index mutual fund is a mutual fund designed to track an index.
Mutual funds and ETFs have different trading structures. Mutual fund transactions are generally processed using the fund's applicable end-of-day net asset value, while ETFs trade on an exchange throughout the trading day.
The exact rules, fees, minimum investments and tax treatment depend on the specific fund and jurisdiction.
Potential Benefits of Index Funds
1. Broad Diversification
A broad index fund can provide exposure to many securities through a single investment.
This can reduce reliance on the performance of one individual company compared with owning only that company.
2. Simple Structure
An index fund can be relatively straightforward to understand: identify the index, review the fund's strategy and understand what the fund owns.
3. Potentially Lower Costs
Many index funds use a rules-based approach and may have lower operating expenses than some actively managed funds.
However, costs vary, so never assume that every index fund is inexpensive.
4. Transparent Investment Objective
A fund's target index gives investors a clear starting point for understanding the market exposure the fund is designed to provide.
5. Less Reliance on Individual Security Selection
Investors using broad index funds do not necessarily need to research and select individual companies one by one.
Risks and Limitations of Index Funds
Index Funds Can Lose Money
Index funds are investments, not guaranteed savings products. Their value can decline when the securities they hold decline.
Tracking Error
An index fund may not perfectly match the performance of its target index.
The difference can result from expenses, trading costs, portfolio sampling, taxes, cash holdings, timing and other factors.
Market Risk
A broad market index can still experience significant declines. Diversification reduces concentration risk but does not eliminate overall market risk.
Concentration Within an Index
Some indexes may have substantial exposure to a relatively small number of companies or sectors.
Investors should examine the actual holdings and weighting methodology instead of assuming that every index provides equal diversification.
Strategy Risk
A narrow index fund can behave very differently from a broad market fund.
For example, a sector-specific index may rise or fall significantly based on developments affecting that industry.
Understanding Index Fund Costs
Costs matter because money spent on fees is money that does not remain invested.
Important costs to review include:
- Expense ratio
- Trading costs
- Bid-ask spread
- Account fees
- Advisory fees
- Other fund-specific expenses
What Is an Expense Ratio?
An expense ratio represents the operating expenses charged by a fund, expressed as a percentage of assets.
For example, if a fund has an expense ratio of 0.10%, the annual operating expense represented by that ratio is approximately 0.10% of the assets, before considering how the fund's assets change.
The actual effect on an investor depends on the fund, account, investment amount and other factors.
Are Index Funds Diversified?
Some index funds are highly diversified but the answer depends entirely on the index being tracked.
A broad-market index may contain hundreds or thousands of securities, while a narrow sector index may contain far fewer holdings.
Before assuming an index fund is diversified, check:
- Number of holdings
- Largest holdings
- Sector exposure
- Geographic exposure
- Asset class
- Index methodology
- Weighting method
How Does Index Weighting Work?
Indexes can use different methods to determine how much weight each security receives.
Common approaches include market-capitalization weighting, equal weighting, price weighting and other rules-based methods.
The weighting method can have a meaningful effect on portfolio exposure.
Market-Capitalization Weighting
In a market-cap-weighted index, companies with larger market values generally receive larger weights.
This means that owning an index fund does not necessarily mean every company represents the same percentage of the portfolio.
What Happens to Dividends in an Index Fund?
Some index funds distribute income generated by the securities they hold. Depending on the fund and account, investors may be able to reinvest those distributions.
Reinvesting distributions can allow additional shares or fractional interests to be purchased, depending on the platform and fund.
Tax treatment varies by account type and jurisdiction.
How to Compare Index Funds
Two funds can both be described as index funds while having very different portfolios, costs, risks and performance.
Before choosing between funds, compare the following factors.
1. What Index Does It Track?
The first question should be what the fund is actually designed to track.
2. What Does the Index Hold?
Review the securities, asset classes, sectors and geographic exposure.
3. Expense Ratio
Compare the ongoing operating costs of similar funds.
4. Tracking Difference
Review how closely the fund has historically followed its target index, while remembering that historical tracking does not guarantee future results.
5. Fund Size and Liquidity
Depending on the fund, size and trading liquidity may affect transaction considerations.
6. Account Availability
Make sure the fund is available through the account or brokerage platform you intend to use.
7. Tax Considerations
Consider how the fund and account may be taxed in your jurisdiction.
Index Fund Comparison Checklist
| Factor | What to Check |
|---|---|
| Target index | Understand exactly what the fund tracks |
| Holdings | Number, largest positions, sectors and geography |
| Expense ratio | Compare ongoing operating expenses |
| Tracking | Review historical difference from the target index |
| Trading | Consider liquidity and transaction costs where relevant |
| Tax treatment | Review applicable rules for your account and country |
Why Index Funds Are Often Associated With Long-Term Investing
Broad index funds are often used in long-term investment strategies because they can provide exposure to many securities through one fund.
A long-term investor may focus on maintaining a suitable asset allocation, contributing consistently, controlling costs and avoiding unnecessary trading.
However, the suitability of any particular index fund depends on the investor's circumstances and the specific fund.
Common Index Fund Mistakes Beginners Make
Mistake 1: Assuming Every Index Fund Is the Same
Different funds track different indexes. Always check the underlying index.
Mistake 2: Looking Only at Past Returns
Historical performance does not guarantee future results. Consider the fund's strategy, costs, risks and role in your overall portfolio.
Mistake 3: Ignoring Fees
Compare expense ratios and other applicable costs before investing.
Mistake 4: Assuming Diversification Eliminates Risk
Diversification can reduce concentration risk but broad markets can still decline.
Mistake 5: Choosing a Fund Without Understanding Its Exposure
A fund's name alone may not tell you everything about its holdings or weighting methodology.
Mistake 6: Chasing a Hot Sector
Narrow sector indexes can experience substantial volatility. Understand the concentration before investing.
Mistake 7: Forgetting the Account
The same investment can have different tax or withdrawal implications depending on the account used.
Can One Index Fund Be Enough?
Whether one index fund is sufficient depends on the fund's exposure and the investor's broader financial situation.
A broad fund may provide substantial diversification within one asset class or market, while a narrower fund may not.
Investors should consider whether their portfolio has appropriate exposure across the asset classes and markets relevant to their goals rather than counting the number of funds alone.
What About International Index Funds?
International index funds can provide exposure to companies or securities outside an investor's domestic market.
International investing can introduce additional considerations, including currency movements, political and economic conditions, different regulations and different market structures.
These factors can affect both risk and returns.
What About Bond Index Funds?
Bond index funds track indexes composed of fixed-income securities.
Bond funds can still lose value. Interest-rate movements, credit quality, maturity, inflation and other factors can affect bond prices and fund performance.
Therefore, "bond" does not mean "risk-free."
A Simple Index Fund Research Process
- Define the financial goal.
- Determine the investment time horizon.
- Understand your tolerance and capacity for risk.
- Identify the account you plan to use.
- Search for funds that match the desired market exposure.
- Read the fund's official documentation.
- Review holdings and diversification.
- Compare expense ratios and other costs.
- Review historical tracking information.
- Understand tax considerations.
- Make sure the investment fits your overall financial plan.
Documents to Review Before Investing
Before purchasing a fund, look for the fund's official documentation and current information.
Depending on the jurisdiction and fund, useful information may include:
- Fund objective
- Investment strategy
- Holdings
- Expense ratio
- Risks
- Historical performance
- Distribution information
- Tax information
- Trading information
Index Fund Checklist for Beginners
- ☐ I understand what an index fund is.
- ☐ I understand the difference between an index and an index fund.
- ☐ I know which index the fund tracks.
- ☐ I understand what the index holds.
- ☐ I have reviewed the fund's diversification.
- ☐ I understand the fund's investment risks.
- ☐ I have checked the expense ratio.
- ☐ I have considered other applicable costs.
- ☐ I understand that the fund can lose value.
- ☐ I understand that past performance does not guarantee future results.
- ☐ I have considered my investment time horizon.
- ☐ I understand the account in which I would hold the fund.
- ☐ I have reviewed applicable tax considerations.
- ☐ I have read the fund's current official documents.
Frequently Asked Questions
What is an index fund in simple terms?
An index fund is a mutual fund or ETF designed to track the performance of a specific market index. Instead of selecting investments primarily to outperform the index, the fund generally seeks to follow it.
Are index funds safe?
Index funds are investments and are not guaranteed to maintain their value. Their risk depends on the securities and index they track. A broad index can still experience significant market declines.
Are index funds good for beginners?
Some beginners consider diversified index funds because they can provide exposure to many securities through one investment. However, whether a particular fund is appropriate depends on the investor's goals, time horizon, risk, costs and overall financial circumstances.
Are all ETFs index funds?
No. ETFs are a fund structure, while an index fund describes a strategy designed to track an index. Some ETFs are actively managed.
Can an index fund lose money?
Yes. If the securities represented by the fund's index decline in value, the index fund can also decline.
What is the expense ratio of an index fund?
The expense ratio represents a fund's operating expenses as a percentage of assets. Different funds have different expense ratios, so investors should check the current fund documents.
Do index funds pay dividends?
Some index funds distribute income generated by the securities they hold. The amount and frequency vary by fund. Tax treatment depends on the account and jurisdiction.
What is the difference between an index fund and a mutual fund?
An index fund describes a fund's strategy of tracking an index. A mutual fund describes a particular fund structure. Therefore, an index fund can be a mutual fund, while not every mutual fund is an index fund.
What is the difference between an index fund and an ETF?
An index fund describes the strategy, while an ETF describes the fund structure. An ETF can be an index fund but ETFs can also use active strategies.
Can I invest in index funds for retirement?
Index funds can be held in certain retirement and taxable investment accounts, depending on the country and account provider. Whether a particular fund fits a retirement plan depends on the investor's goals and circumstances.
How many index funds should I own?
There is no universal number. The relevant question is whether the overall portfolio provides appropriate exposure and diversification for the investor's goals rather than how many funds are held.
Final Thoughts
Index funds are designed to track specific market indexes and have become an important part of many long-term investment strategies.
Their simplicity, potential diversification and often competitive costs can make them worth understanding but an index fund is not automatically appropriate simply because it tracks an index.
Before investing, look beyond the fund's name. Understand the underlying index, holdings, weighting methodology, costs, risks, account structure and tax considerations.
The most useful investment decision is one that fits your own financial goals, time horizon, risk considerations and broader financial plan.
