What Is an Index Fund? A Beginner’s Guide to Investing in Index Funds

What Is an Index Fund? A Comprehensive Guide to Understanding Index Funds

An index fund is a mutual fund or an exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index. (An index is a collection of investments grouped based on common characteristics.) Although you can’t invest directly into an index, you can invest into an index fund, which follows its movement. A professional manager collects money from investors and buys the securities that make up the index. For example, the Standard and Poor’s 500 Index is a market-capitalization-weighted index of 500 large U.S. companies selected by using a combination of quantitative and qualitative factors. It tracks the average performance of these stocks, although not all 500 have to gain for the index to rise. An S&P 500 index fund follows that performance, so its value goes up or down in tandem with the S&P 500. Buying an index fund may give you similar results to buying individual stocks in an index — without the work and expense. With most index funds, a single share costs less than buying shares in each stock or bond that makes up the index, making it a more accessible option.

Journalist

Investment Analyst and Chief Editor

Investment expert

2 more Hide

Updated November 21

Common Types of Index Funds

There are index funds based on several themes, such as:

Broad Market: Tracks a wide range of industries and companies to give a comprehensive picture of the entire stock market.
Sector: Aimed at specific sectors, e.g., Technology, Healthcare.
Domestic: Focused on investments within the U.S.
International: Follows foreign markets but is still available through U.S. brokerages.
Bond: Invests in bond indexes such as corporate or government bonds.
Dividend: Tracks companies that pay high dividends and frequently passes along payouts to investors.
Socially Conscious: Avoids companies that don’t meet certain ethical standards, such as those that damage the environment.
Growth: Focuses on companies or sectors that are believed to grow faster than the broader market.
Value: Targets undervalued investments with high performance potential.

Commonly Tracked Indexes

Examples of popular indexes that index funds track include:

S&P 500: Index of 500 top U.S. companies.
Nasdaq Composite Index: Heavy concentration and dependence on technology stocks.
Russell 2000: Includes more than 2,000 smaller U.S. firms.
Bloomberg U.S. Aggregate Bond Index: A broad measure of U.S. corporate and government bonds.

Advantages of Index Funds

Diversification: Investing in hundreds, if not thousands, of securities simultaneously allows investors to spread risk across multiple industries and companies.
Reduced Fees: Managers charge lower fees for index replication than for active management of portfolios. For instance, as of March 2024, the Fidelity® 500 Index Fund has an expense ratio of 0.015% versus 1% or greater for actively managed funds.
Lower Chance of Human Error: Index funds track an index, so there’s less room for bias and error on an individual basis.
Tax Efficiency: Because index funds trade less often, they generate less taxable distributions to investors.

Disadvantages of Index Funds

Average Market Returns: Returns are equal to the average for the index, including both high- and low-performing securities.
Expense Ratios: You pay a percentage of your returns in the form of an expense ratio, which, while usually low, adds up over time.
Investment Minimums: Certain funds require minimum investments, although many ETFs offer fractional shares from as little as $1.
Tracking Errors: The fund and the index may not match perfectly, affecting returns.
No Downside Protection: Index funds ride out market declines; active managers can reallocate to reduce losses.
No Control: Investors cannot select or reject individual securities in the fund.

How to Invest in Index Funds

Open an Investment Account: Choose a retirement account (such as an IRA) or a nonretirement brokerage account. Research brokers for fees, available index funds, and ease of use.
Fund Your Account: Deposit money into your account to begin investing.
Choose Index Funds: Look at objectives, historical performance, and expense ratios to ensure that these fit within your investment goals. Search for tools such as fund screeners to evaluate options.
Finalize the Purchase: Use your account to purchase shares in the index fund you have selected.