Index Fund
An index fund is a mutual fund or ETF that tries to match the return of a market index, such as the S&P 500, by holding the same securities. It trades less and usually charges far lower fees than actively managed funds.
Most professional fund managers fail to beat their benchmark after costs over the long run. Index funds take the opposite approach: don't try to beat the market, just own it cheaply. That simple idea made them one of the most popular investments in the world. This entry explains how index funds work, why their costs are low, and where they fall short.
- Category
- Trading Basics
- Reading time
- 4 min
- Also called
- Index funds, Index tracker, Tracker fund
- Updated
Index funds in plain words
An index fund can be a mutual fund, an ETF or a unit investment trust that follows a passive strategy aiming for about the same return as a chosen index before fees.1
It does this mainly by buying the stocks or bonds in that index, sometimes using a representative sample or derivatives.1
Passively managed funds of this kind are what people usually mean by "index funds".2
How an index fund works, step by step
Pick an index
Such as the S&P 500 or a total bond market index. See Stock Market Index.
Hold its members
In the same weights, or a representative sample.
Follow index changes
Buy additions and sell removals. See Index Inclusion and Rebalancing.
Keep trading low
Little turnover means low costs.
Charge a small fee
Often a fraction of active-fund fees. See Expense Ratio.
Track closely
Returns match the index minus fees and tracking error.
Worked examples
Example 1 — Matching the market
≈ market returnThe index returns 10% in a year. The index fund charges 0.05%.
| Index return | 10% |
| Fund return | 10% − 0.05% = 9.95% |
An index fund aims for about the index's return before fees, so its result is roughly the market minus a small cost.1
Example 2 — Index vs active over 20 years
Index ahead by ≈ $15,548$20,000 in two funds earning 8% before costs: one charges 0.1%, the other 1.1%.
| Index (7.9%) | $20,000 × 1.079^20 ≈ $91,508 |
| Active (6.9%) | $20,000 × 1.069^20 ≈ $75,960 |
| Difference | ≈ $15,548 |
Passive funds usually have lower fees than active ones, and over time higher fees can significantly lower returns.1
Example 3 — No escape from a crash
−$15,000The index falls 30% in a bear market. You hold $50,000 in the fund.
| Loss | $50,000 × 30% = $15,000 |
| Value | $35,000 |
A passive fund follows the index down as well as up; the manager will not move to cash to protect you. See Bear Market.
Index fund vs actively managed fund
| Aspect | Index fund | Active fund |
|---|---|---|
| Goal | Match the index | Beat the index |
| Trading | Low | Higher |
| Fees | Low | Higher |
| Depends on manager skill | Hardly | Heavily |
How investors use index funds
Core holding
A cheap base for a long-term portfolio. See Portfolio.
Retirement saving
Regular contributions over decades. See Dollar-Cost Averaging.
Benchmark exposure
Getting the market return without stock picking. See Benchmark.
Tax-loss swaps
Switching between similar index funds. See Tax-Loss Harvesting.
Advantages and disadvantages
Advantages
- Very low fees.
- Broad diversification.
- Less trading, so fewer taxable gains.
Disadvantages
- Never beats the index.
- Falls fully with the market.
- Cap-weighted indexes concentrate in the biggest companies.
Going deeper
Read as far as you need. Each level builds on the one before it.
Why costs are low
Beginner
Passive management usually means less trading, which lowers transaction costs and realised capital gains, and lower fees than active funds.1
Active funds' hurdle
Intermediate
Tracking error
Advanced
Sampling, cash holdings, fees and index changes mean the fund's return drifts slightly from the index. That gap is tracking error. See Benchmark.
Common mistakes
Thinking index means safe
It is as risky as the market it tracks.
Ignoring what the index holds
A tech-heavy index is not diversified across sectors.
Owning many overlapping funds
Several S&P 500 funds add nothing.
Selling in a crash
Index investing works only if you stay invested.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Index funds try to match an index, not beat it.
- They can be mutual funds or ETFs.
- Low trading means low fees and fewer taxable gains.
- They fall with the market in a crash.
- Fees compound into big differences over time.
Frequently asked questions
Is an S&P 500 fund an index fund?
Are index funds good for beginners?
Do index funds pay dividends?
Further learning
- Stock Market Index
What the fund tracks.
- Mutual Fund
One way index funds are packaged.
- Exchange-Traded Fund
The other common wrapper.
- Alpha
What active funds try to add.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Investor.gov (SEC). Index Fund (glossary) (opens in a new tab) Checked .
- Investor.gov (SEC). Characteristics of Mutual Funds and Exchange-Traded Funds (ETFs) – Investor Bulletin (opens in a new tab) Checked .
- Investor.gov (SEC). Active Fund or Actively Managed Fund (glossary) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.