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

Index funds aim to mirror the performance of benchmarks like the S&P 500 by mimicking their makeup. These passive investments, long considered an unimaginative way to invest, are behind a quiet revolution in U.S. equity markets as they seize the attention and dollars of a widening swath of investors. The numbers tell the story: passive index funds tracking market benchmarks accounted for just 21% of the U.S. equity fund market in 2012. By 2023, passive funds had crossed above 50% of assets, beating their actively traded peers.

The seismic shift has come as index funds have convincingly outperformed their active fund peers. According to the widely followed S&P Indices Versus Active (SPIVA) scorecards, about 9 out of 10 actively managed funds didn't match the returns of the S&P 500 benchmark over the previous 15 years. Rather than having some unique stock-picking wizardry, critics argue that managers of actively traded funds have only demonstrated a magical power for extracting higher fees for themselves while returning less to clients. Whatever the outcome of these debates over fund performance, for many who once put their faith in what those fees in actively managed funds bought, the spell has clearly been broken.

To see why, below, we unpack what index funds are and how they work. We'll discuss the benefits and drawbacks of building a portfolio with index funds along the way.

Key Takeaways

  • An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
  • Mutual funds and exchange-traded funds (ETFs) have many different varieties of low-cost index funds.
  • They have lower expenses and fees than actively managed funds.
  • Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market.
  • Index funds should match the risk and return of the market based on the theory that, in the long term, the market will outperform any single investment.

What Are Index Funds, and How Do They Work? (1)

What Are Index Funds?

Indexes and index funds exist for almost any part of the financial market. Index funds invest in the same assets using the same weights as the target index, typically stocks or bonds. If you're interested in the stocks of an economic sector or the whole market, you can find indexes that aim to gain returns that closely match the benchmark index you want to track. Index funds use a passive investing strategy, trading as little as possible to keep costs low.

For broad indexes like the S&P 500 that would be impractical or expensive to do on your own, index funds do the work for you by holding a rep sample of the securities. S&P 500 index funds, the most popular in the U.S., mimic the moves of the stocks in the S&P 500, which covers about 80% of all U.S. equities by market cap.

The portfolios of index funds only change substantially when their benchmark indexes change. If the fund follows a weighted index, its managers may periodically rebalance the weights (the percentage by market cap) and components of their fund's securities to keep matched with the target index.

Besides the S&P 500, these funds mirror other major indexes like the Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, which follows the total U.S. dollar-denominated bond market; and the Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies chosen by the editors of the Wall Street Journal.

Index funds provide broad market exposure and diversification across various sectors and asset classes according to their underlying index. The broader index funds are often quite good at keeping tracking errors low (the difference between the fund's performance and the target index). However, you'll want to thoroughly review any fund's fees and performance before investing. To give an idea of how close the funds should track their targets, as of March 2024, Fidelity's Nasdaq Composite Index Fund (FNCMX) had a 10-year average annual return of 15.16% versus 15.23% for the Nasdaq composite, a 0.07% difference.

Investing in index funds means putting your money not behind the skills of active fund managers but on the prospects for the market or its parts.

Benefits of Index Funds

The primary advantage index funds have over their actively managed peers is lower fees. So, if actively managed funds don’t outperform their passive peers, more investors are asking, why are clients paying fund managers so much more in fees each year? Using SPIVA data as a proxy, which compares the performance of actively managed funds with certain benchmarks, 87% of actively traded funds had underperformed the S&P 500 the previous five years (from data last published in mid-2023). When you extend that to 15 years, it's 92%.

A greater public understanding of statistics like these helps explain the growing popularity of passive funds, almost all of which are index funds. You still have to pay an expense ratio with these funds, which is charged as a percentage of the assets under management to pay to advisors and managers and cover transaction fees, taxes, and accounting costs. Since the managers of index funds are simply replicating the performance of a benchmark index, they don't need research analysts and others to choose stocks, timing trades, etc. They also trade holdings less frequently, meaning fewer transaction fees and commissions. By contrast, actively managed funds have large staffs and conduct trades with more complications and volume, driving up the costs.

As such, index funds can charge less than their actively trading peers. They often cost about 0.05% or less—compared with the higher fees that actively managed funds command, typically 0.44% and sometimes higher than 1.00%, depending on the assets. What does this fee buy you? Passively managed funds don't try to beat the market—they want to match it.

Here are some more of these funds' advantages:

  1. Lower costs: Index funds typically have lower expense ratios because they are passively managed.
  2. Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.
  3. Transparency: Since they replicate a market index, the holdings of an index fund are well-known.
  4. Historical performance: Over the long term, many index funds have outperformed actively managed funds, especially after accounting for fees and expenses.
  5. Tax efficiency: Lower turnover rates in index funds usually result in fewer capital gains distributions, making them more tax-efficient than actively managed funds.

These funds have many virtues that make them well-suited for ordinary long-term investors. That said, the best choice for you—active or passive, or any fund at all—will depend more on your financial goals, the investment environment, risk tolerance, and other specifics about your situation than these general characteristics.

Drawbacks of Index Funds

Among the critiques of index funds is their inherent lack of flexibility. Because they are designed to mirror a specific market, they decline in value when the market does, and they can't pivot away in an unfavorable environment. Similarly, they are also criticized for automatically including all the securities in an index. This means they may invest in companies that are overvalued or fundamentally weak, leaving aside greater weighting or investments in assets that could be chosen by a fund manager and provide better returns. Of course, this automated strategy has often outperformed active management, perhaps in part by holding onto assets that active fund managers have misjudged.

Another disadvantage has to do with what's called market-cap weighting, which many index funds use. Companies with higher market capitalizations have a greater influence on the fund's performance in such funds. This concentration can lead to being too tied to the fate of a few large companies, magnifying your risks if these companies underperform.

Best Index Funds

Best Index Funds
Fund NameMinimum InvestmentExpense Ratio10-Yr Avg. Annual Return
Vanguard 500 Index Fund Admiral Shares (VFIAX)$3,0000.04%12.60%
Fidelity Nasdaq Composite Index Fund (FNCMX)$00.29%15.16%
Fidelity 500 Index Fund (FXAIX)$00.015%12.69%
Vanguard Total Stock Market Index Fund Admiral (VTSAX)$3,0000.04%12.06%
Schwab S&P 500 Index Fund (SWPPX)$00.02%12.73%
Schwab Total Stock Market Index Fund (SWTSX)$00.03%12.00%
Schwab Fundamental US Large Company Index Fund (SFLNX)$00.25%11.36%
USAA Victory Nasdaq-100 Index Fund (USNQX)$3,0000.44%17.97%
Fidelity Total Bond Fund (FTBFX)$00.45%2.28%

Index Mutual Funds vs Index ETFs

If you're interested in index funds, you'll likely have to choose between investing in mutual funds or ETFs that track specific indexes. Both are funds replicating the performance of a specific market index. However, they differ in several key aspects that can influence your decision depending on your investment goals and strategy.

Index mutual funds pool money to buy a portfolio of stocks or bonds. Investors buy shares directly from the mutual fund company at the net asset value (NAV) price, which is calculated at the end of each trading day. Among the main advantages of index mutual funds in the chart below are the simplicity of automatically reinvesting dividends and dollar-cost averaging (making regular set contributions).

Index ETFs, meanwhile, are traded on exchanges like individual stocks. This lets investors employ far more trading strategies: timing ETF share trades, using limit or stop-loss orders, short selling, etc., which are among the benefits of Index ETFs found below.

Index Mutual Funds vs. Index ETFs
Index Mutual FundsIndex ETFs
PurposePassively track a specific market index, shares bought/sold from the fund companyPassively track a specific market index, shares traded on an exchange
Management StylePassivePassive
PricingNAV calculated once per day at market closeReal-time market price throughout the trading day, can slightly deviate from NAV.
TradingBought/sold at the end of the day at NAVBought/sold throughout the day like stocks
FeesTypically lower fees than actively managed mutual funds, but often slightly higher than comparable ETFsGenerally low fees
Tax ImplicationsSince mutual funds must pass on realized capital gains to shareholders, this can create an annual tax liability if gains are realized by the fund manager, though fund managers have ways to minimize this.ETFs have a creating/redeeming structure for creation units as it rebalances, so it's not exposed to capital gains that would have to be passed on.
LiquidityLess liquid than ETFsHighly liquid
ProsEasy for dollar-cost averaging, automated reinvestment of dividends, dollar-cost averaging (contributing fixed amounts regularly)Intraday trading flexibility including the ability to put in stop losses or limit orders for managing risk, can be bought in individual shares for price accessibility,
ConsLimited trading times, minimum investment, potentially higher feesPotential for wider bid-ask spreads during volatility, trading commissions if brokerage charges for trades
ExamplesVanguard S&P 500 Index Fund (VFIAX)SPDR S&P 500 ETF (SPY)

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Example of an Index Fund

Index funds have been around since the 1970s, but have exploded in popularity over the past decade or so. The fund that started it all, founded by Vanguard chair John Bogle in 1976, remains among the best as judged by its long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. As of March 2024, Vanguard’s Admiral Shares (VFIAX) posted an average 10-year average annual return of 12.75% vs. the S&P 500’s 12.78%—a very small tracking error. The expense ratio is low at 0.04%, and its minimum investment is $3,000.

How To Invest in Index Funds

Investing in index funds is straightforward for both new and experienced investors. Here’s how to get started investing in index funds:

  1. Choose your investment platform: Begin by selecting an online brokerage or investment platform (we have some ideas).
  2. Open and fund an account: Once you’ve chosen a platform, you’ll need to open an account. This typically involves providing personal information, setting up login credentials, and completing a questionnaire about investment goals and risk tolerance. After that, you’ll need to deposit funds. This can usually be done through a bank transfer.
  3. Select an index fund: Research different funds to understand their performance history, management fees, and the indexes they track. Consider diversifying your portfolio by investing in several index funds.
  4. Buy shares: With your account funded, you can now buy shares of your chosen fund. Most platforms allow you to purchase directly through their website or app with just a few clicks.
  5. Monitor and adjust as needed: While index funds are typically long-term investments, reviewing your portfolio periodically is wise to ensure it aligns with your financial goals.

Are Index Funds Better Than Stocks?

Index funds track portfolios composed of many stocks or bonds. As a result, investors benefit from the positive effects of diversification, such as increasing the expected return of the portfolio while minimizing the overall risk. While any individual stock may see its price drop steeply, if it's a relatively small part of a larger index, it won't be as damaging.

What Are the Best Index Funds for Retirement?

The best index funds for retirement offer growth potential and solid risk management that aligns with your time to retirement and risk tolerance. For long-term growth, consider broad-market equity index funds like the Vanguard Total Stock Market Index Fund (VTSAX) or the Fidelity 500 Index Fund (FXAIX). For diversification and income, bond index funds like the Fidelity Total Bond Fund (FTBFX) can be a good choice. Target-date retirement funds, which automatically adjust their allocation as your retirement approaches, can also be a convenient option for retirement planning.

Are Index Funds Good for Beginners?

Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified. Index funds have lower expense ratios than most actively managed funds, making them affordable, and often outperform them, too. These reasons make them a solid choice not only for beginners, but many expert investors as well. A final bonus for newer investors: if your fund is tied to a main index like the S&P 500 or Nasdaq composite, you'll see news coverage of it often, helping you keep abreast of your investment while learning the broader market's ebbs and flows.

How Much Should You Pay for an Index Fund?

Index funds generally have low annual fees, and these fees, on average, have been declining over the past several years. According to the last-published data from the Investment Company Institute in 2023, the average fee for an index fund is 0.04%, with some index funds offering even lower expense ratios. All else being equal, you might wish to choose the lower-cost fund among those that equally track the same index well.

The Bottom Line

Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds. They are designed to replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing, such as in retirement accounts. While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management. Despite these limits, index funds are often favored for their consistent performance and are now a staple in many investment portfolios. Consider your investment objectives and risk tolerance when choosing an index fund. Talking first with a financial advisor for personalized advice is always prudent.

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