An index fund holds the same stocks or bonds as a published market index, so its value moves with that index instead of trying to beat it

An index fund is a collection of investments — usually stocks or bonds — that mirrors a specific market index. An index is a published list of securities that represents a slice of the market. The S&P 500, for example, is an index of 500 large U.S. companies. When you own shares in an S&P 500 index fund, you own a small piece of all 500 companies in that same proportion. If the S&P 500 goes up 10 percent, your fund goes up roughly 10 percent. If it falls 5 percent, your fund falls roughly 5 percent.

The fund manager's job is not to pick winning stocks or time the market. It is to hold the exact securities in the index and keep costs low. This is different from an actively managed fund, where a manager tries to beat the index by choosing which stocks to buy and sell. Index funds charge lower fees because there is less work involved — the manager straightforward buys what the index contains and rebalances when the index changes.

Key Takeaways

  • An index fund owns the same securities as its benchmark index in the same weights, so it rises and falls with that index rather than trying to outperform it.
  • Common index funds track the S&P 500, the total U.S. stock market, international stocks, or bond indexes, depending on what part of the market you want to own.
  • Index funds charge lower fees than actively managed funds because the manager straightforward replicates the index instead of researching and trading individual securities.
  • You can buy index funds through a brokerage account, a retirement account like a 401(k) or IRA, or an employer-sponsored plan.

How an index fund tracks its benchmark

When you buy an index fund, you are buying into a fund that holds a basket of securities. The fund company decides which index to track — the S&P 500, the Nasdaq-100, the Bloomberg U.S. Aggregate Bond Index, or dozens of others. The fund then purchases all (or a representative sample) of the securities in that index in the same proportions.

If Apple makes up 7 percent of the S&P 500, an S&P 500 index fund will hold Apple as roughly 7 percent of its portfolio. When the index is rebalanced — which happens on a published schedule — the fund rebalances too. The fund's value per share, called its net asset value or NAV, moves almost exactly with the index. The small difference between the fund's performance and the index's performance is called tracking error, and it is usually caused by fees and the timing of trades.

Different index funds track different indexes. A total stock market index fund holds thousands of U.S. companies of all sizes. A bond index fund might hold government bonds, corporate bonds, or a mix. An international index fund holds stocks from other countries. You choose the fund based on which part of the market you want to own.

Why fees matter more in index funds

Because an index fund's goal is to match its index, not beat it, the fund's fee is the main thing that determines whether you come out ahead or behind. The fee is expressed as an expense ratio — a percentage of your investment charged each year. A fund with a 0.03 percent expense ratio costs $3 per year for every $10,000 you own. A fund with a 0.50 percent expense ratio costs $50 per year on the same $10,000.

Over decades, that difference compounds. If two index funds track the same index but one charges 0.03 percent and the other charges 0.50 percent, the cheaper fund will have significantly more money at the end because less of your gains go to fees. This is why comparing expense ratios across index funds that track the same index is one of the most important decisions you can make.

Some index funds also charge a transaction fee when you buy or sell shares. Others do not. Many brokerages now offer commission-free trading on index funds, so you can buy and sell without paying a per-trade fee. Always check whether a fund charges a transaction fee before you buy.

Common types of index funds and what they hold

Index funds exist for almost every part of the market. Here are the ones you will encounter most often:

  • S&P 500 index funds hold the 500 largest U.S. companies. They represent about 80 percent of the total U.S. stock market by value.
  • Total U.S. stock market index funds hold thousands of U.S. companies of all sizes — large, mid-size, and small. They cover the entire U.S. stock market in one fund.
  • International index funds hold stocks from developed countries outside the U.S., such as Japan, Germany, and the United Kingdom.
  • Emerging market index funds hold stocks from faster-growing countries like Brazil, India, and China.
  • Bond index funds hold government or corporate bonds. They move differently than stock funds and are often used to balance risk in a portfolio.
  • Target-date index funds hold a mix of stock and bond index funds, with the mix changing as you get closer to retirement.

Each type serves a different purpose in a portfolio. Some investors use a single total market index fund to own everything at once. Others combine multiple index funds to customize how much of their money goes to U.S. stocks, international stocks, and bonds.

Where you can buy index funds

You can buy index funds through several types of accounts. A brokerage account is a regular investment account with no contribution limits and no rules about when you can withdraw money. You pay taxes on gains and dividends each year. A retirement account like a traditional IRA or Roth IRA lets you invest up to a set amount per year and delays or eliminates taxes on gains.

If your employer offers a 401(k) or similar retirement plan, you can often choose from a list of index funds to invest in. Many employers also match a portion of your contributions, which is information programs. Some people also own index funds in a taxable brokerage account alongside retirement accounts, to invest more than the annual retirement account limits allow.

To buy an index fund, you open an account with a brokerage firm — such as Vanguard, Fidelity, Charles Schwab, or others — search for the index fund you want by name or ticker symbol, and place an order. The order is filled at the end of the trading day at that day's NAV. You can set up automatic monthly investments if you want to buy a fixed dollar amount regularly.

Index funds versus actively managed funds

An actively managed fund employs a manager or team to research companies, decide which ones to buy and sell, and try to beat the index. This requires more work, more trading, and higher fees. Actively managed funds charge expense ratios that often range from 0.50 percent to 2 percent or higher.

Over long periods, most actively managed funds do not beat their index. After accounting for fees and taxes, the average actively managed fund underperforms its benchmark. This is why many investors choose index funds — they cost less, they are transparent (you always know what you own), and they match the market's return instead of trying to beat it and usually falling short.

That said, some actively managed funds do outperform their indexes over certain periods. The challenge is knowing which ones will do so in the future. Index funds remove that guessing game by accepting market returns and keeping costs low.

Frequently Asked Questions

Can I lose money in an index fund?

Yes. If the index the fund tracks goes down, your fund goes down. Index funds that hold stocks can fall 20, 30, or even 50 percent during market downturns. Index funds that hold bonds are generally less volatile but can still lose value if interest rates rise. The longer you hold the fund, the more time you have to recover from downturns.

Do index funds pay dividends?

Many do. When the companies in the index pay dividends, the fund collects them and passes them to you. You can choose to reinvest dividends back into the fund or receive them as cash. Reinvesting dividends is often the better choice for long-term growth because you earn returns on the dividends themselves.

What is the difference between an index fund and an ETF?

An exchange-traded fund (ETF) is a type of index fund that trades on a stock exchange like a stock does. You can buy and sell it throughout the day at changing prices. A traditional index fund is priced once per day after the market closes. ETFs often have lower expense ratios and are more tax-efficient, but they may charge a commission depending on your brokerage.

How often should I check my index fund?

You do not need to check it often. Index funds are designed for long-term holding. Checking daily or weekly can tempt you to buy or sell based on short-term price swings, which usually hurts returns. Most investors check their accounts quarterly or annually to make sure their overall portfolio still matches their goals.

Can I own multiple index funds at once?

Yes. Many investors own several index funds to spread their money across different parts of the market — for example, a U.S. stock index fund, an international stock index fund, and a bond index fund. This is called diversification. Make sure the funds do not overlap too much, or you will own the same companies multiple times.