What Is an Index Fund and How Does It Work?

An index fund gives you a way to invest in a group of securities without choosing each one yourself.

The fund follows a specific market index. If that index holds hundreds of companies, the fund may give you exposure to many of those companies through a single investment.

That simplicity has made index funds a common building block in long-term investment portfolios.

Investor.gov defines an index fund as a mutual fund or exchange-traded fund designed to track the returns of a particular market index before fees.

New to investing? Our investing for beginners guide and the wider Investing section cover the fundamentals.

What Is a Market Index?

A market index measures the performance of a selected group of investments.

You have probably heard of indexes such as:

• S&P 500
• Russell 2000
• Dow Jones Industrial Average
• broad U.S. total-market indexes

Each index follows its own rules.

Some track large U.S. companies. Others focus on smaller companies, bonds, international markets, industries, or particular investment styles.

You cannot buy an index directly.

An index fund creates an investable portfolio designed to follow one.

A Simple Example

Imagine an index follows 500 large U.S. companies.

Instead of researching and buying shares in hundreds of companies yourself, you could buy an index fund that tracks that index.

Your investment would then rise and fall based largely on the performance of the securities the fund holds, minus the fund’s costs and any tracking differences.

You own shares of the fund.

The fund owns the underlying investments.

How Does an Index Fund Track an Index?

Some index funds buy every security included in the index.

Others use a representative sample.

A fund may also use techniques such as derivatives to help follow its benchmark.

The goal is usually to produce a return close to the index before fees, rather than choosing securities based on a manager’s prediction about which ones will perform best.

That approach is usually described as passive investing.

What Does Passive Investing Mean?

An actively managed fund has a manager or team making decisions about what to buy and sell.

They may study companies, economic conditions, valuations, interest rates, or other factors and try to outperform a benchmark.

An index fund generally follows a different process.

Its manager follows the rules of the chosen index.

When the index changes, the fund adjusts.

When the index gives one company a particular weighting, the fund tries to reflect that weighting.

This often means less portfolio trading and less need for a large research team. Investor.gov notes that passive management can result in lower transaction costs and lower fees than many actively managed funds, although this is not guaranteed.

Index Funds Can Be ETFs or Mutual Funds

This point trips up many new investors.

An index fund describes the investment strategy.

An ETF or mutual fund describes the fund structure.

You can buy:

• an index ETF
• an index mutual fund
• an actively managed ETF
• an actively managed mutual fund

So an ETF is not automatically an index fund.

A mutual fund is not automatically actively managed.

If you want to know how a fund invests, read its objective and strategy. For a fuller side by side, see our guide to stocks vs ETFs vs mutual funds.

Index ETFs

An index ETF trades on an exchange during the day.

You buy and sell shares through a brokerage account, much like a stock.

The market price changes while the market is open.

That price may occasionally sit slightly above or below the value of the fund’s underlying assets.

Many investors use index ETFs because they combine diversified fund exposure with exchange trading.

Index Mutual Funds

An index mutual fund also follows a market index.

The main trading difference is that mutual fund shares are generally bought or redeemed at the fund’s next calculated net asset value, usually after the market closes.

You do not trade a traditional mutual fund throughout the day the way you trade an ETF.

For someone investing regularly for decades, that difference may matter very little.

How Are Companies Weighted Inside an Index?

Not every company necessarily receives the same share of an index.

Many widely followed indexes use market capitalization weighting.

Market capitalization is broadly calculated as:

share price × shares outstanding

A company with a larger market value receives a larger weighting in a market-cap-weighted index.

This means the biggest companies can have a much greater effect on index performance than smaller companies.

Other indexes use different rules.

The Dow Jones Industrial Average, for example, uses price weighting.

Still others use factors such as company size, dividends, value characteristics, financial strength, or custom quantitative rules.

Index Fund Does Not Mean “Own the Whole Market”

An index fund only owns what its chosen index tells it to own.

A broad total-market fund may hold thousands of securities.

A sector index fund may hold companies from one industry.

A small-cap index fund may focus on smaller companies.

A bond index fund may own no stocks at all.

Some newer index funds follow highly specialized benchmarks built around themes or investment factors.

Investor.gov warns that non-traditional index funds can use more complex strategies and may carry higher expenses than traditional broad-market index funds.

Check the index before you check the recent return.

Why Investors Use Index Funds

Diversification

A broad index fund can spread your money across many securities.

If one company performs poorly, the entire portfolio does not depend on that one result.

Diversification can reduce company-specific risk.

It cannot prevent losses when the overall market falls.

Lower Costs Can Help

Passive funds often require less security research and less trading than actively managed funds.

That can result in lower operating expenses.

Fees deserve attention because every dollar paid in fees is a dollar that remains unavailable to compound in your portfolio.

Investor.gov notes that if two funds produce identical investment performance before costs, the lower-cost fund will generally leave more of the return with the investor.

Simplicity

A broad index fund can give you exposure to hundreds or thousands of investments through one holding.

That can make portfolio construction easier.

You still need to decide which asset classes you want, how much risk you can take, and how the fund fits with your other investments.

Transparency

Many index funds follow clearly defined benchmarks.

You can usually find out which index the fund tracks, what the index contains, and how the fund is structured.

That makes it easier to understand what you own.

Index Funds Still Have Fees

“Passive” does not mean free.

Index funds may charge:

• expense ratios
• trading costs
• account-related fees
• other fund expenses

ETF investors may also face bid-ask spreads when trading.

Different funds tracking similar markets can charge very different fees.

Never assume an index fund is cheap because it has “index” in the name.

Read the fee table.

What Is an Expense Ratio?

The expense ratio represents the fund’s annual operating expenses as a percentage of assets.

Suppose a fund charges 0.10 percent annually.

That works out to roughly $10 per year for every $10,000 invested, although the expense is reflected within fund performance rather than arriving as a separate invoice.

A fund charging 0.75 percent would cost considerably more over time.

The difference becomes more important as your balance and holding period grow.

What Is Tracking Error?

An index fund will rarely match its index perfectly.

The difference between the fund’s performance and its benchmark is often called tracking error or tracking difference.

Several factors can contribute:

• fund fees
• trading costs
• sampling rather than owning every security
• cash held inside the fund
• timing differences when the index changes

Investor.gov identifies tracking error as one of the risks index fund investors should understand.

A fund that tracks its benchmark closely may still trail the index slightly because the index itself does not pay the fund’s operating expenses.

Index Funds Can Lose Money

An index fund follows its index down as well as up.

If a broad stock index falls 25 percent, a fund tracking it may experience a similar decline before accounting for costs and tracking differences.

The fund manager usually cannot simply sell everything because the market looks dangerous.

Following the index is the strategy.

This is one reason your asset allocation matters.

A stock index fund may be suitable for one part of a long-term portfolio while being inappropriate for money you need next year.

An S&P 500 Fund Is Diversified, but Only Within Part of the Market

A fund tracking the S&P 500 can provide exposure to hundreds of large U.S. companies.

That gives you much more company diversification than owning a handful of individual stocks.

Still, it represents one segment of the global investment universe.

It does not automatically give you broad exposure to:

• smaller U.S. companies
• international stocks
• bonds
• cash
• every asset class

The word “diversified” always needs context.

Two Index Funds Can Be Very Different

Suppose Fund A tracks a broad U.S. stock market index.

Fund B tracks an index of 30 cybersecurity companies.

Both are index funds.

Their risk profiles are very different.

Fund A spreads exposure across a wide range of businesses and industries.

Fund B concentrates on one industry.

If cybersecurity stocks fall sharply, Fund B may feel the full effect.

The index fund label tells you how the fund follows its strategy.

It does not tell you whether the strategy is broad, conservative, aggressive, or suitable for you.

Market-Cap Weighting Can Create Concentration

Broad index funds can become heavily influenced by their largest holdings.

If several giant companies grow rapidly, their weights inside a market-cap-weighted index can become substantial.

You may own hundreds of stocks and still have a meaningful share of the portfolio concentrated in a relatively small group of very large companies.

Look at the fund’s top holdings.

Also check how much of the portfolio those holdings represent.

What About Equal-Weight Index Funds?

Some indexes give each company an equal weighting rather than weighting companies by market value.

For example, an index containing 100 companies might start each holding at roughly 1 percent.

That produces a different portfolio from a market-cap-weighted version of the same group.

Equal-weight strategies may require more frequent rebalancing and can behave quite differently.

Again, the important question is:

What rules does this index follow?

Index Funds and Taxes

Taxes depend partly on whether you hold the fund in a taxable account or a tax-advantaged account such as an IRA.

Index funds often trade less frequently than actively managed funds, which can reduce realized capital gains inside the portfolio.

Investor.gov notes that passive management can sometimes produce more favorable tax consequences because of lower portfolio turnover.

ETF structures can also have tax characteristics that differ from traditional mutual funds.

Tax efficiency varies.

It does not mean tax-free.

How Index Funds Fit Into Asset Allocation

Index funds can provide the building blocks for an asset allocation.

For example, an investor might use separate index funds covering:

• U.S. stocks
• international stocks
• bonds
• other desired asset classes

The percentages assigned to each determine the overall portfolio risk far more than the fact that the holdings happen to be index funds.

An aggressive stock index portfolio remains aggressive.

A conservative bond-heavy index portfolio behaves very differently.

Start with asset allocation.

Then choose suitable funds to implement it.

Index Funds Inside a 401(k)

Many employer retirement plans offer index mutual funds.

You may see options such as:

U.S. large-cap index

total market index

international index

bond index

Names vary between retirement plans.

Look beyond the name.

Check:

• which index it tracks
• expense ratio
• investment holdings
• risk level
• how it fits with your other retirement investments

Your workplace plan may also include target-date funds that hold several underlying index funds.

Index Fund vs Individual Stocks

An individual stock gives you exposure to one company.

A broad index fund spreads exposure across many.

Owning individual companies gives you more control over exactly what you hold.

It also creates greater company-specific risk and usually requires more research.

Some investors use index funds for most of their portfolio and keep a smaller allocation for individual stocks.

Others use index funds exclusively.

The appropriate choice depends on your goals, interests, risk tolerance, and willingness to manage the portfolio.

Index Fund vs Actively Managed Fund

The philosophical difference is straightforward.

An index fund generally aims to follow a benchmark.

An active fund generally gives a manager discretion to select investments according to the fund’s strategy and often tries to outperform a benchmark or achieve another stated goal.

Active management can outperform.

It can also underperform.

Higher fees create an additional gap that the manager needs to overcome before delivering better net results to investors.

Compare actual costs, strategy, risks, and long-term performance rather than assuming one structure always wins.

What to Check Before Buying an Index Fund

Before investing, answer these questions:

1. Which index does the fund track?
2. What securities are actually inside the fund?
3. How concentrated are the largest holdings?
4. What is the expense ratio?
5. Is it an ETF or mutual fund?
6. How closely has it tracked its benchmark?
7. Does it overlap heavily with funds you already own?
8. Does the fund fit your asset allocation and timeframe?

Read the prospectus and most recent shareholder information before putting money into a fund. The SEC specifically recommends reviewing these materials when evaluating index funds.

A Practical Example

Suppose you want long-term exposure to the broad U.S. stock market.

You find two index funds.

Both appear to track similar markets.

Fund A charges a low expense ratio and covers thousands of companies.

Fund B costs considerably more and follows a narrower index.

Before choosing, compare:

• benchmark
• holdings
• expense ratio
• fund structure
• tracking history
• overlap with your current investments

The cheaper fund may be attractive.

The broader fund may suit your goal better.

Or the second fund may provide exposure you specifically want.

The ticker symbol alone does not answer the question.

Keep the Job of the Fund Clear

Every holding in your portfolio should have a reason for being there.

Maybe an index fund provides your core U.S. stock exposure.

Another handles international stocks.

A bond index fund reduces overall portfolio volatility.

When you understand each fund’s job, the portfolio becomes easier to manage.

You also reduce the temptation to keep adding funds simply because they have performed well recently.

The Bottom Line

An index fund is a mutual fund or ETF designed to track a market index.

It can offer broad diversification, relatively low costs, and a simple way to gain exposure to a market.

Those benefits depend on the fund you choose.

Check the benchmark.

Check the holdings.

Check the fees.

Check how the fund fits your asset allocation.

Then decide whether it serves the financial goal you are investing for.

Related Guides

• Index Funds vs ETFs: What’s the Difference?
• Investing for Beginners: A Practical Introduction
• Stocks vs ETFs vs Mutual Funds: Understanding the Differences
• Asset Allocation Explained: How Stocks, Bonds and Cash Fit Together
• How Compound Interest Works: Why Time Matters More Than You Think

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