What an index fund is

An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds a collection of stocks or bonds chosen to match a specific market index. Instead of a manager picking individual investments, the fund straightforward buys and holds the same stocks that make up an index — like the S&P 500, the Nasdaq-100, or the total U.S. stock market.

The goal is straightforward: your money grows at roughly the same rate as the index itself. If the S&P 500 goes up 10 percent in a year, an S&P 500 index fund should also go up about 10 percent (minus a small fee). You are not betting on a manager's skill to pick winners; you are betting on the overall direction of the market segment the index represents.

Key Takeaways

  • Index funds hold the same stocks or bonds as a published market index, so their performance tracks that index rather than depending on a manager's choices.
  • The main advantage is lower fees than actively managed funds, because no team is constantly buying and selling to try to beat the market.
  • You can buy index funds through a brokerage account, a retirement account like an IRA or 401(k), or sometimes directly from a fund company.
  • Index funds are available for many different markets — U.S. stocks, international stocks, bonds, real estate, and combinations of all three.
  • The value of an index fund changes every trading day based on the prices of the stocks or bonds it holds.

How index funds differ from actively managed funds

An actively managed fund pays a team of analysts to research companies, decide which ones to buy and sell, and try to beat the market. That research and trading costs money — usually 0.5 to 2 percent of your investment per year in fees. An index fund does none of that. It straightforward buys the stocks in the index and holds them, rebalancing only when the index itself changes. That costs far less — often 0.03 to 0.20 percent per year.

Over long periods, this fee difference matters. If two funds both earn 7 percent before fees, but one charges 1.5 percent and the other charges 0.10 percent, you keep more of your money in the cheaper fund. Studies have shown that most actively managed funds do not beat their index benchmarks after fees, which is why many investors choose index funds instead.

Types of index funds you can buy

Index funds exist for nearly every part of the market. The most common is the S&P 500 index fund, which holds the 500 largest U.S. companies. Other popular choices include total U.S. stock market funds (which hold thousands of companies of all sizes), total international stock funds, bond index funds, and real estate index funds.

You can also find index funds that track narrower slices — technology stocks, healthcare stocks, emerging markets, or dividend-paying stocks. Some funds combine multiple indexes into a single investment, like a "three-fund portfolio" that holds U.S. stocks, international stocks, and bonds all in one fund.

The index a fund tracks is always in its name. A fund called "Vanguard S&P 500 ETF" tracks the S&P 500. A fund called "iShares Core Total U.S. Stock Market ETF" tracks the total U.S. stock market. Reading the name and the fund's description tells you exactly what you own.

Where to buy index funds

You can buy index funds through a brokerage account — an account at a company like Fidelity, Charles Schwab, Vanguard, or E-Trade where you can buy and sell investments. You open the account, deposit money, search for the index fund you want, and place an order just like buying a stock.

You can also hold index funds inside a retirement account. A traditional IRA or Roth IRA lets you buy index funds with money set aside for retirement. A 401(k) through your employer often includes index fund options alongside actively managed funds. Some employers even offer index funds as the default investment if you do not choose one yourself.

Some fund companies also let you buy directly from them without going through a brokerage. Vanguard, Fidelity, and others allow direct purchases of their own funds. The process is the same: you open an account, deposit money, and buy shares of the fund.

How index fund prices work

An index fund's price — called its net asset value or NAV — changes every trading day based on the prices of the stocks or bonds inside it. If the stocks in the S&P 500 go up on a given day, the S&P 500 index fund's price goes up. If they go down, the price goes down.

The price is calculated by adding up the current market value of every holding in the fund and dividing by the number of shares outstanding. You can see the price at any time during market hours on your brokerage website or the fund company's website. When you buy or sell, you get whatever the price is at the end of that trading day — not the price you see on your screen right now.

Costs and fees to know about

The main cost of owning an index fund is the expense ratio — the annual fee charged as a percentage of your investment. A fund with a 0.10 percent expense ratio costs $10 per year for every $10,000 you own. This fee is deducted automatically; you do not pay it separately.

Some index funds also charge a transaction fee when you buy or sell — though many brokerages now offer commission-free trading on index funds. A few funds charge a redemption fee if you sell within a certain time period, usually to discourage short-term trading. Always check the fund's prospectus or fact sheet to see what fees explore.

If you buy an index fund inside a retirement account, you may also pay account maintenance fees to the brokerage, though many waive these for accounts above a certain balance. These are separate from the fund's expense ratio.

Why people choose index funds

Index funds appeal to investors for several reasons. The low fees mean more of your money stays invested and compounds over time. They are straightforward to understand — you know exactly what you own because it matches a published index. They require no research into individual companies or trust in a manager's judgment. And historically, they have performed as well as or better than most actively managed funds over long periods.

Index funds also make it straightforward to diversify. A single S&P 500 index fund gives you ownership in 500 large companies across many industries. A total market fund gives you thousands. You get broad exposure to the market without having to pick individual stocks.

Frequently Asked Questions

Can I lose money in an index fund?

Yes. If the stocks or bonds in the index go down in value, your fund's value goes down too. The stock market has periods of decline — sometimes lasting months or years. However, historically the market has recovered from every downturn and reached new highs over longer time periods. Index funds are generally considered less risky than individual stocks because they spread your money across many companies.

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

Both can track an index, but they trade differently. A traditional index mutual fund is priced once per day at the market close, and you buy or sell at that price. An index ETF trades throughout the day like a stock, so the price changes minute by minute. ETFs often have slightly lower expense ratios and may be more tax-efficient. For most investors, the differences are small enough that either works.

Do I have to hold an index fund forever?

No. You can sell whenever you want during market hours. However, index funds work best as long-term holdings because they are designed to track the market over years or decades, not to be traded frequently. If you sell during a market downturn, you lock in losses. Most investors buy index funds and hold them for years or decades as part of a retirement or long-term savings plan.

How often does an index fund buy and sell stocks?

Very rarely. The fund buys the stocks that make up the index when you first invest, and holds them. The only time the fund trades is when the index itself changes — for example, when a company is added to or removed from the S&P 500. This happens infrequently, which is one reason index funds have such low fees and are tax-efficient.

Can I use index funds in a retirement account?

Yes. Most retirement accounts — IRAs, Roth IRAs, 401(k)s, and others — allow you to hold index funds. Many employers offer index funds as options in their 401(k) plans. Using index funds in a retirement account is a common strategy because the low fees mean more of your money compounds over the decades until retirement.