What Are Index Funds? How Do They Work? (2024)

An index fund is a type of mutual fund that aims to duplicate the performance of a financial market index, like the S&P 500. This strategy is called passive management—instead of trying to actively beat a benchmark, an index fund aims to be the benchmark.

Index funds are a great way to simplify investing while also reducing your costs. Most of the fund options in workplace 401(k) plans are index funds, but you can also own them in an individual retirement account or a taxable brokerage account.

What Is a Market Index?

A financial market index groups together assets of a similar type—stocks or bonds, currencies or commodities—and tracks their price performance over time. Investors follow indexes to get a grasp on how markets are performing.

The S&P 500 is the most widely followed market index, as it tracks the stock prices of 500 of the largest U.S. public companies. This group of stocks represents about 80% of the market capitalization of all stocks traded in the U.S., and it is commonly referred to as a stand-in for the entire U.S. stock market.

Market indexes make it simple to understand whether the stock market as a whole is gaining ground or losing value. Other leading stock indexes include theDow Jones Industrial Average, the Nasdaq Composite and the Russell 2000.

How Do Index Funds Work?

Every index fund tracks a market index. Fund managers create portfolios that mirror the makeup of their target index with a goal of duplicating its performance. For example, an would own the stocks included in the index and attempt to match the overall performance of the S&P 500.

As with other mutual funds, when you buy shares in an index fund you’re pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.

The fund manager regularly adjusts the share of the assets in the fund’s portfolio to match the makeup of the index. By doing so, the return on the fund should match the performance of the target index, before accounting for fund expenses.

Why Index Weighting Matters for Index Funds

Market indexes use what are called weighting strategies to give appropriate representation to their underlying assets, and the choice of strategy can have a big impact on how an index fund performs.

A price-weighted index takes into account each asset’s market price. Higher-priced assets have a bigger share in the index than lower-priced assets. The DJIA is a price-weighted index, since the price per share of each component stock determines its weighting in the index.

A market-cap-weighted index considers each asset’s market capitalization, or the total amount of money invested in the asset, to determine its share in the index. The S&P 500 is a market-cap weighted index, as each component company’s market capitalization determines its share of the index.

Why does this matter? An index fund that tracks a price-weighted index needs to adjust its portfolio holdings frequently to keep up with its target index as prices fluctuate. With a market-cap weighting, there is less need for buying and selling to keep the fund aligned with its target. However, large-cap assets can have an outsized impact on the performance of both the index and any fund that tracks it.

An equal-weight indexgives the same weighting in its calculation to each asset it tracks, independent of price or market cap, large or small. For an index fund, that means no single holding has an outsized impact—positive or negative—on performance.

Passive Investing With Index Funds

Index funds are passive investments. There is debate over the virtues of actively managed mutual funds vs passive index funds, but a strong case can be made that passive funds are less expensive and may have better returns over the long term.

Managers of actively managed mutual funds attempt to outperform a benchmark index. For example, an actively managed fund that measures its performance against the S&P 500 would try to exceed the annual returns of that index via various trading strategies. This approach requires more involvement by managers and more frequent trading—and therefore higher potential costs.

Passive management doesn’t try to identify winning investments. Instead, managers of an index fund merely attempt to duplicate the performance of their target index. This strategy requires fewer managerial resources and less trading, which means index funds usually charge lower fees than actively managed mutual funds.

Advantages of Index Funds

• Low fees. Index funds charge lower fees than actively managed mutual funds. Fund managers merely track an underlying index, which requires less effort and fewer trades than attempting to actively beat a benchmark index.
• Easy diversification.When you buy shares of a single index fund, you gain access to an investment portfolio made up of a very large basket of securities. The time and expense to build and maintain a similar portfolio yourself would likely be prohibitive.
• Long-term growth potential.Over the past 90 years, the S&P 500 has earned an average return of nearly 10% per year. That’s one of the highest returns of any investment and one that even professional investors struggle to beat. By buying into an S&P 500 or other equity index fund, your investments are set to grow for the long term.

Disadvantages of Index Funds

• Average annual returns. Index funds may provide a high degree of diversification, but this also means they deliver only average annual returns. Index funds can dilute the possibility of big gains as they are driven by the combined results of a very large basket of assets.
• Little chance for big short-term gains.As passive investing vehicles, there’s little scope for capturing big short-term gains with index funds. While this is more of a feature of index funds, not a bug, investors seeking sizable short-term gains should not expect them from index funds.
• Not much downside protection. If the market has a bad day—or falls into bear territory—your index fund probably will, too. By their nature, index funds typically have little flexibility to respond to declines in the prices of their underlying assets. Investors must be patient and wait for a recovery.

What Are the Different Kinds of Index Funds?

Investors have a wide selection of index funds to choose from. These are some of the most common categories:

• Broad market index funds. Also called total market index funds, they attempt to duplicate the performance of an entire investable market. For example, the Vanguard Total Bond Market Index Fund (ticker VBTLX) attempts to match the performance of the entire U.S. bond market by buying up thousands ofdifferent types of bondswith different maturities.
• Equity index funds. Equity index funds track specific stock indexes. Equity index funds that track the S&P 500 are among the largest and most popular index funds. There are index funds that track all the major stock indexes, such as the Nasdaq Composite or the Russell 2000.
• Bond index funds. Also called fixed income index funds, these funds track the performance of specific types of bonds. Bond index funds invest in corporate debt, government bonds and municipal bonds of varying maturities and quality.
• Balanced index funds.These funds invest across asset classes. For example, a balanced index fund portfolio could be 60% stocks and 40% bonds.
• Sector index funds.They’re specific to industrial sectors. For example, the manager of a consumer staples index fund would only buy stocks in the S&P 500 consumer staples category, including companies in the food, beverage, and household goods businesses.
• Dividend index funds. If your goal is to generate income, check out these funds, which focus only on indexes of stocks paying high dividends.
• International index funds.To invest outside the United States, you could buy into an international index fund. They track indexes in other countries like the DAX in Germany or the Nikkei in Japan.
• Socially responsible investing index funds. A social index fund looks to promote causes like protecting the environment or improving workplace diversity. The fund would only invest in companies that meet its mission, so an environmental fund would skip buying oil companies.

How To Choose an Index Fund

You should understand your overall investing goals before you choose an index fund. Do you want to generate predictable income as you head into retirement? Consider dividend index funds or investment-grade bond funds.

Are you at the beginning of your career and looking for long-term growth? Equity index funds offer great long-term growth benefits. Want even more diversification? Balanced funds can provide it.

Whichever funds catch your eye, it’s important to understand that there are many funds that track the same indexes but charge different fees. Firms like Morningstar provide accessible toolsfor comparing and contrasting index funds on the basis of fees and performance. Consulting with a financial advisor can help you refine your investing goals and compare different index fund options.