What an index fund is

An index fund is a mutual fund or exchange-traded fund (ETF) that holds the same stocks or bonds as a published market index. Instead of a manager picking which companies to buy, the fund simply owns all the companies in the index it tracks — or a representative sample of them. The fund's performance will closely match the index's performance, minus a small fee.

The most common index funds track the S&P 500 (500 large U.S. companies), the Nasdaq-100 (100 large technology and growth companies), or the total U.S. stock market. Bond index funds track indexes of government or corporate debt. International index funds track stocks or bonds outside the United States.

Because index funds simply copy an index rather than employ a manager to make trading decisions, they cost far less to run than actively managed funds. That lower cost is passed to you as a lower fee, often between 0.03% and 0.20% per year.

Key Takeaways

  • Index funds hold all or most of the securities in a published index, so their returns match the index's returns minus fees.
  • You can buy index funds as mutual funds (which trade once per day) or as ETFs (which trade throughout the day like stocks).
  • Index funds charge lower fees than actively managed funds because no manager is making individual stock picks.
  • The index fund you choose determines what you own — an S&P 500 fund owns large U.S. companies, while a total bond market fund owns government and corporate debt.

How index funds track their benchmark

When you buy shares of an S&P 500 index fund, you own a tiny piece of all 500 companies in that index. If Apple makes up 7% of the S&P 500's total value, your fund holds roughly 7% of its money in Apple stock. If Microsoft is 6%, your fund holds roughly 6% in Microsoft.

The fund rebalances periodically — usually once or twice a year — to keep those percentages in line with the index. When a company leaves the index or a new one joins, the fund buys or sells shares to match. This mechanical approach means the fund's value will rise and fall almost exactly with the index.

Some index funds use sampling instead of holding every single security. A very large bond index might contain thousands of bonds, so the fund manager selects a representative subset that behaves the same way. This reduces trading costs and still tracks the index closely.

Mutual funds versus ETFs

You can own an index fund in two legal structures: a mutual fund or an exchange-traded fund (ETF). Both track an index the same way, but they trade differently.

A mutual fund trades once per day, after the market closes. You place an order during the day, but the price you pay is set at 4 p.m. Eastern time. You cannot see the exact price until after you have committed to the trade. Mutual funds are bought directly from the fund company or through a brokerage account.

An ETF trades throughout the day like a stock. You can buy or sell at any time the market is open and see the price before you commit. ETFs are bought through a brokerage account, the same way you would buy individual stocks. Many investors prefer ETFs because of this intraday trading and because ETF fees are often slightly lower.

Why fees matter in index funds

Index funds charge an annual fee called an expense ratio, expressed as a percentage of the money you have invested. A fund with a 0.05% expense ratio costs $5 per year for every $10,000 you own. A fund with a 0.50% expense ratio costs $50 per year on the same $10,000.

This difference compounds over decades. If two index funds track the same index but one charges 0.05% and the other charges 0.50%, the cheaper fund will have significantly more money after 20 or 30 years, simply because less of your gains went to fees. When comparing index funds that track the same index, the lowest-cost option is usually the best choice.

Some index funds also charge a transaction fee when you buy or sell shares. Many brokerages now offer commission-free trading on index funds and ETFs, so you can avoid this cost entirely by choosing a brokerage that does not charge it.

Index funds versus actively managed funds

An actively managed fund pays a manager (or team of managers) to research companies and decide which ones to buy and sell. The manager aims to beat the index — to earn higher returns than simply owning the index itself. This active management is expensive: fees typically run 0.50% to 2.00% per year or higher.

Research shows that most actively managed funds do not beat their index over long periods, especially after fees are subtracted. An index fund that costs 0.10% per year will often outperform an actively managed fund that costs 1.00% per year, even if the manager is skilled, simply because the fee difference is so large.

This does not mean active management never works, but it means the burden is on the actively managed fund to prove it can beat the index by enough to justify its higher cost. For most investors, index funds offer a simpler, lower-cost way to own a diversified portfolio.

What index funds own and how to choose one

The index you choose determines what you own. An S&P 500 index fund owns large U.S. companies. A total U.S. stock market index fund owns large, mid-size, and small U.S. companies. A total bond market index fund owns government bonds, investment-grade corporate bonds, and mortgage-backed securities. An international stock index fund owns companies outside the United States.

Many investors build a portfolio by combining several index funds — for example, 60% in a U.S. stock index fund, 20% in an international stock index fund, and 20% in a bond index fund. This approach is called index fund investing or passive investing. It is simple, low-cost, and diversified.

When choosing an index fund, look at three things: the index it tracks (does it match what you want to own?), the expense ratio (is it among the lowest for that index?), and whether your brokerage charges a transaction fee to buy it (can you trade it commission-free?).

How index funds fit into a long-term investment plan

Index funds work best as long-term holdings. Because they track a market index, they will rise and fall with that market. In some years they gain 20% or more; in other years they lose 10% or 20%. If you need the money within five years, the timing of a market downturn could force you to sell at a loss.

For money you will not need for at least seven to ten years, index funds offer a straightforward way to grow wealth. You buy them, hold them, and let compound growth work. You do not need to monitor them closely or trade frequently. You simply rebalance once or twice a year to keep your target mix of stocks and bonds.

Index funds also work well inside retirement accounts like 401(k)s and IRAs, where you do not pay taxes on gains each year. Over decades, this tax deferral compounds significantly.

Frequently Asked Questions

Can I lose money in an index fund?

Yes. If the index the fund tracks falls in value, your fund falls too. The S&P 500 has dropped 20% or more in several years since 1980. However, it has always recovered and reached new highs within a few years. If you hold the fund for at least seven to ten years, historical data suggests you are unlikely to lose money overall.

Do I need to pick individual stocks if I own index funds?

No. An index fund gives you instant diversification across dozens or hundreds of companies. You do not need to research or pick individual stocks. Many investors own only index funds and never buy individual stocks.

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. An index fund holds a fixed mix — it does not change based on your age. Target-date funds are simpler for hands-off investors; index funds give you more control over your allocation.

Can I buy index funds through my employer's 401(k)?

Most 401(k) plans offer at least a few index fund options. Check your plan's investment menu. Index funds in 401(k)s often have slightly higher fees than the same funds bought outside a 401(k), but they are still usually cheaper than actively managed options in the plan.

How often should I rebalance an index fund portfolio?

Once or twice per year is typical. If you own 60% stocks and 40% bonds, and stocks rise so much that you now own 70% stocks, you can sell some stock index funds and buy bond index funds to get back to 60/40. This keeps your risk level consistent without requiring constant trading.