An index fund is a collection of stocks or bonds that mirrors a specific market list
An index fund is a fund that holds the same stocks or bonds as a published market index. An index is simply a list — like the S&P 500, which tracks 500 large U.S. companies, or the Nasdaq-100, which tracks 100 technology and growth companies. When you own shares in an index fund, you own a small piece of all the stocks in that list.
The fund manager does not pick which stocks to buy. Instead, they buy whatever stocks are on the index, in the same proportions. If Apple makes up 7% of the S&P 500, then Apple makes up roughly 7% of an S&P 500 index fund. When the index changes — when a company is added or removed — the fund changes too.
This is different from an actively managed fund, where a manager chooses which stocks to buy and sell, trying to beat the market. An index fund simply tracks the market.
Key Takeaways
- An index fund holds all or most of the stocks in a specific market index, so you own a piece of many companies with one purchase.
- The fund automatically rebalances when the index changes, without a manager making individual stock picks.
- Index funds typically charge lower fees than actively managed funds because there is less work involved.
- You can buy index funds through a brokerage account, and they trade during market hours like individual stocks.
- Different indexes track different markets — some focus on U.S. stocks, others on international stocks, bonds, or specific sectors.
Why index funds cost less than other funds
An index fund has lower operating costs because the manager is not researching companies or making trading decisions. The fund simply buys the stocks on the index and holds them. This means less staff time, fewer trades, and lower transaction costs.
These savings show up in the fund's expense ratio — the annual fee you pay, expressed as a percentage of your investment. An S&P 500 index fund might charge 0.03% to 0.20% per year, while an actively managed fund tracking the same market often charges 0.50% to 1.50% or more. Over decades, that difference compounds significantly.
Common indexes and what they track
Different indexes measure different parts of the market. Here are the ones you will encounter most often:
| Index Name | What It Tracks | Number of Holdings |
|---|---|---|
| S&P 500 | Large U.S. companies | 500 |
| Nasdaq-100 | Large technology and growth companies | 100 |
| Dow Jones Industrial Average | 30 very large U.S. companies | 30 |
| Russell 2000 | Small and mid-sized U.S. companies | 2,000 |
| MSCI World | Large companies in developed countries worldwide | 1,500+ |
| Bloomberg U.S. Aggregate Bond | U.S. government and corporate bonds | 10,000+ |
You can also find index funds that track specific sectors — energy, healthcare, financials — or specific countries. The index you choose determines what part of the market you own.
How to buy an index fund
You buy index funds through a brokerage account, the same way you would buy individual stocks. Open an account with a brokerage firm (Vanguard, Fidelity, Charles Schwab, and others offer them), deposit money, and search for the index fund you want by its ticker symbol or name.
Most index funds trade during regular market hours, so you can buy or sell shares any time the stock market is open. Some brokerages let you set up automatic monthly investments, which means money moves from your bank account to the fund on a schedule you choose.
You will see index funds offered as mutual funds or as exchange-traded funds (ETFs). Both track an index, but they trade slightly differently. A mutual fund order processes after the market closes; an ETF trades in real time like a stock. For most people, the difference does not matter much.
What happens when the index changes
Indexes are not static. Companies are added when they meet the index's size or quality standards, and removed when they no longer do. When S&P Dow Jones Indices decides to add Tesla to the S&P 500, every S&P 500 index fund automatically buys Tesla shares. When a company is removed, the fund sells.
This rebalancing happens automatically — you do not have to do anything. The fund manager handles it. This is one reason index funds require so little active management.
The relationship between index funds and market performance
An index fund's return tracks the index it follows, minus its fees. If the S&P 500 rises 10% in a year and your S&P 500 index fund charges 0.10% in fees, your return will be roughly 9.90%. You will not beat the market, but you will not fall far behind it either.
This is actually a strength for many investors. Most actively managed funds do not beat their index over long periods, even before fees. By owning an index fund, you get the market's return at a low cost, without betting that a manager will pick winning stocks.
Frequently Asked Questions
Can I lose money in an index fund?
Yes. If the stocks in the index fall in value, the fund falls too. Index funds are not may provide investments. Over very long periods — 20 years or more — stock market index funds have historically recovered from downturns, but there is no certainty, and shorter time periods can show losses.
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 to you or reinvests them automatically, depending on how you set up your account. You can usually choose which option you prefer.
What is the difference between an index fund and a target-date fund?
A target-date fund holds multiple index funds (and sometimes bonds) and automatically shifts the mix as you approach retirement. An index fund holds one specific index. Target-date funds are more hands-off; index funds give you more control over what you own.
Can I buy an index fund inside a retirement account?
Yes. Index funds are available in most 401(k) plans, IRAs, and other retirement accounts. Many financial advisors recommend index funds for retirement savings because of their low costs and steady performance over decades.
What if I want to own international stocks?
You can buy an index fund that tracks an international index, like the MSCI EAFE (Europe, Australasia, Far East) or the MSCI Emerging Markets. Some investors own both U.S. and international index funds to spread their holdings across regions.