Index Funds: What They Are, How They Work & How to Invest
Index funds are investment funds designed to track a market index. Learn how index funds work, how index mutual funds differ from index ETFs, what fees to check, how diversification works, and what risks to understand before investing.
An index fund is a mutual fund, ETF, or similar investment vehicle designed to track the performance of a particular market index. Instead of selecting individual securities to try to outperform an index, the fund generally follows the index's holdings or a representative sample of them.
What Is an Index Fund?
An index fund is a type of investment fund that seeks to track the returns of a particular market index. The index may represent a broad group of stocks, a particular part of the stock market, bonds, or another segment of the investment market.
Examples of indexes that funds may track include the S&P 500, Russell 2000, and Wilshire 5000. You cannot directly invest in an index itself. An index fund provides an investment vehicle designed to follow the index.
An index is a measurement or benchmark. An index fund is an investment product designed to track that benchmark.
How Do Index Funds Work?
An index fund generally follows a passive investment strategy. Instead of having a manager frequently select securities in an attempt to outperform a benchmark, the fund is designed to follow the composition and methodology of its chosen index.
Some funds hold all of the securities in an index. Others may hold a representative sample. The exact strategy depends on the fund and the index it tracks.
Index construction can also differ. Some indexes weight companies according to market capitalization, while other indexes use different weighting methods.
What Is Passive Investing?
Passive investing generally means building an investment portfolio around a market index or another predetermined strategy rather than frequently selecting securities in an attempt to outperform the market.
Because an index fund generally does not require the same level of security selection and trading as an actively managed fund, its operating costs may be lower. However, an index fund is not automatically the lowest-cost option. Investors should check the actual expenses of each fund.
Index Funds and Diversification
One reason investors use index funds is that a single fund can provide exposure to many securities. The amount of diversification depends on the index the fund tracks.
For example, a broad-market index may contain hundreds or thousands of securities, while a narrowly focused index may contain a much smaller group of companies.
Diversification can reduce the effect that one security has on a portfolio, but it does not eliminate investment risk. A broad stock-market index fund can still decline when the overall stock market falls.
Types of Index Funds
Index funds are not all the same. Before investing, look at what the underlying index actually represents.
- Broad U.S. stock index funds: Designed to provide exposure to a broad segment of the U.S. stock market.
- Large-cap index funds: Focus on larger companies.
- Small-cap index funds: Track indexes focused on smaller companies.
- International index funds: Provide exposure to companies outside the United States.
- Bond index funds: Track indexes made up of bonds or other fixed-income securities.
- Sector index funds: Focus on a particular industry or economic sector.
- Total-market index funds: Seek exposure to a broad portion of a market.
Index Mutual Funds vs. Index ETFs
Both mutual funds and ETFs can use an index-tracking strategy. The main difference is how the investment products are structured and traded.
| Feature | Index Mutual Fund | Index ETF |
|---|---|---|
| Investment strategy | May track a market index | May track a market index |
| How shares trade | Transactions are generally processed using the fund's calculated NAV | Trades on an exchange during market hours |
| Purchase method | Through a fund company or brokerage | Through a brokerage account |
| Minimums | May have an investment minimum depending on the fund | Usually purchased by shares, subject to brokerage and fund availability |
| Price during the day | Transactions use the applicable NAV | Market price changes throughout the trading day |
Index Fund Fees and Expenses
Investment costs matter because fees reduce the amount of money that remains invested. Two funds tracking similar indexes can have different expenses.
Expense Ratio
An expense ratio expresses a fund's annual operating expenses as a percentage of its assets. It is one of the key costs to review when comparing funds.
Other Costs
Depending on the fund and account, investors may also encounter trading costs, account fees, advisory fees, transaction fees, or other expenses.
Do not assume that every index fund has the same cost. Review the fund's current documents and fee information before investing.
What Is Tracking Error?
An index fund is designed to follow an index, but its performance may not exactly match the index.
Differences can result from expenses, trading costs, portfolio sampling, taxes, cash holdings, and other factors. The difference between a fund's performance and its benchmark is commonly referred to as tracking difference or tracking error, depending on the context.
When researching an index fund, compare its historical performance with the index it is designed to track, while remembering that past performance does not guarantee future results.
Risks of Index Funds
Index funds are investments and can lose value. The risks depend largely on the securities and strategy represented by the underlying index.
- Market risk: The value of the fund can fall when the securities in the underlying market decline.
- Concentration risk: A narrowly focused index may be heavily exposed to a particular sector, country, company size, or industry.
- Tracking risk: The fund may not perfectly match its benchmark.
- Interest-rate risk: Some bond index funds can be affected by changes in interest rates.
- International risk: International funds can be affected by currency, political, economic, and regulatory conditions in other countries.
Index Funds vs. Actively Managed Funds
| Feature | Index Fund | Actively Managed Fund |
|---|---|---|
| Strategy | Generally seeks to track an index | Manager selects investments according to the fund's strategy |
| Trading activity | Generally lower portfolio turnover | Can involve more frequent trading |
| Goal | Generally seeks to follow a benchmark | May seek to outperform a benchmark |
| Fees | May be relatively low, but varies | Varies by fund |
| Flexibility | Generally constrained by the index | Manager may have more discretion |
How to Invest in Index Funds
- Define your goal. Determine whether you are investing for retirement, a long-term financial goal, or another purpose.
- Choose an account. Depending on your circumstances, this could include a taxable brokerage account, IRA, 401(k), or another eligible investment account.
- Research the index. Understand what securities the index contains and how they are selected and weighted.
- Research the fund. Review its expense ratio, holdings, investment objective, historical tracking, minimum investment, and other costs.
- Fund your account. Transfer money into the investment account according to the account provider's process.
- Place your investment order. Follow your brokerage or fund provider's process for purchasing the fund.
- Monitor your plan. Review whether the fund continues to match your investment goals and desired asset allocation.
What to Check Before Buying an Index Fund
Comparing two index funds involves more than looking at the name of the index. Consider the following information:
- What index does the fund track?
- What securities are included?
- How is the index constructed and weighted?
- What is the expense ratio?
- Are there transaction or account-related costs?
- Does the fund have an investment minimum?
- How closely has the fund followed its benchmark?
- What risks are associated with the underlying index?
- Is the fund a mutual fund or ETF?
- Does the investment fit your overall portfolio?
Index Funds and Taxes
Tax treatment depends partly on the type of account in which you hold the fund.
In a taxable brokerage account, distributions from a fund and sales of fund shares can have tax consequences. Capital gains and losses may also arise when you sell shares for more or less than your tax basis.
Investments held in tax-advantaged accounts can have different tax rules. For example, traditional and Roth retirement accounts have different tax characteristics.
Tax rules can change and individual circumstances differ. Consider current IRS guidance or professional tax advice when making tax decisions.
Investing Regularly in Index Funds
Some investors contribute money to their investment accounts on a regular schedule. Regular contributions can make investing part of a broader financial routine.
A recurring investment schedule does not eliminate market risk. The value of the investment can still rise or fall, and the amount purchased with each contribution can vary depending on the fund's price.
Index Funds and Retirement Accounts
Index funds can be available inside different types of retirement accounts, depending on the account provider and investment options offered by the plan.
A workplace 401(k), for example, may offer one or more index-based investment options. An IRA can also provide access to index mutual funds or ETFs through a brokerage.
The account and the investment are separate concepts: the account determines the tax and withdrawal framework, while the fund determines what investments your money is exposed to.
Simple Index Fund Example
Suppose an investor purchases an index fund designed to track a broad U.S. stock index. Instead of purchasing individual shares of every company represented by the index, the investor owns shares of the fund.
If the securities represented by the index increase or decrease in value, the fund's value will generally move in a similar direction, although the fund's actual performance can differ because of fees, expenses, portfolio management, and tracking differences.
An index fund can lose value. Historical performance should not be treated as a guarantee of future investment results.
Common Index Fund Mistakes
- Assuming every index fund is broadly diversified.
- Choosing a fund without checking the underlying index.
- Looking only at past returns.
- Ignoring expense ratios and other costs.
- Assuming the fund will exactly match its index.
- Ignoring concentration in a specific sector or market.
- Investing without considering the account's tax rules.
- Changing investments frequently because of short-term market movements.
Index Fund Beginner Checklist
- Define your investment goal.
- Determine your time horizon.
- Choose an appropriate investment account.
- Understand the index being tracked.
- Review the fund's holdings.
- Compare expense ratios and other costs.
- Review tracking performance.
- Understand the fund's risks.
- Consider how the fund fits with your other investments.
- Review current fund documents before investing.
Frequently Asked Questions
What is an index fund?
An index fund is an investment fund designed to track the performance of a particular market index. Index funds can be structured as mutual funds or ETFs.
Are index funds the same as ETFs?
No. An ETF describes a fund structure that trades on an exchange. An index fund describes an investment strategy designed to track an index. An ETF can be an index fund, but not every ETF is an index fund.
Are index funds diversified?
Some index funds provide broad diversification, while others track narrow indexes. The level of diversification depends on the underlying index.
Do index funds have fees?
Yes. Index funds have expenses and may have other costs. Investors should review the current expense ratio, transaction costs, account fees, and other applicable charges.
Can index funds lose money?
Yes. Index funds are investments and can lose value when the securities they hold decline. Diversification does not eliminate market risk.
How do I choose an index fund?
Start by understanding the index the fund tracks. Then review its holdings, investment strategy, expense ratio, other costs, tracking performance, risks, and how it fits your overall investment plan.
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