What is an index fund?
An index is a list with rules. The S&P 500, for example, holds about 500 large US companies chosen by a committee and weighted by market value, so the biggest companies carry the most weight. The guides to stock market indexes and market cap explain both ideas.
An index fund buys the stocks on that list in the same proportions and adjusts when the list changes. Nobody at the fund decides which company looks cheap or exciting; the rules do, which is why index investing is called passive. When you buy one share of the fund, as in the drawing above, you own a small slice of every company in the index.
- Index fund
- A mutual fund or ETF that holds the stocks of a market index in the index’s proportions, aiming to match its return rather than beat it.
Index ETF vs index mutual fund: which index funds are common?
The same index can come in two wrappers. An index mutual fund is bought from the fund company at one price calculated after the market closes. An index ETF (exchange-traded fund) trades on the exchange all day like a stock, through an ordinary brokerage account, which makes ETFs the usual route for investors buying US funds from abroad. The what is an ETF guide covers how ETFs work.
The index matters more than the wrapper. Common examples:
- S&P 500 funds: about 500 large US companies. SPY, IVV and VOO are ETFs that track this same index.
- Total-market funds: thousands of US companies of all sizes, large, mid and small. VTI is one example.
- Nasdaq-100 funds such as QQQ: 100 of the largest non-financial companies listed on Nasdaq, more concentrated in technology.
- Funds for other countries, sectors and bonds, built the same way on other indexes.
Why the expense ratio matters: costs compound too
Every fund charges a yearly fee, the expense ratio, taken from the fund’s assets. You never see a bill; your return is simply lower. Broad index funds are often among the cheapest funds available, but costs still differ, and small differences grow over decades.
Hypothetical: $10,000 invested for 30 years in two funds that hold the same stocks and grow 7% a year before costs, with the fee subtracted from each year’s return. In the drawing below, a 0.05% yearly cost grows the money to about $75,000; a 1.00% cost, to about $57,000. The gap of about $18,000 is the fees plus the growth those fees would have earned. Real returns are never this smooth, and 7% is an assumption, not a forecast.
When funds track the same index, also compare the tracking difference and, for ETFs, the bid-ask spread you pay to trade. The share price itself does not matter: a $500 share and a $50 share of the same index move by the same percentage.
- Expense ratio
- The fund’s yearly cost as a percentage of the money invested, deducted inside the fund. 0.05% means $5 a year per $10,000.
- Tracking difference
- How far a fund’s return ends up from its index’s return over a period, mostly because of costs.
Passive vs active funds: which is better?
An active fund pays a manager to pick stocks and try to beat the index; an index fund only tries to match it, as the table below compares. Active funds usually cost more, so they must beat the index by more than that extra cost just to come out even.
S&P Dow Jones Indices publishes SPIVA scorecards that compare active funds with their benchmarks. Its US reports have repeatedly found that most active US stock funds trailed their benchmark over long periods such as 15 years. Some active funds do outperform, but picking them in advance is hard, and past results do not predict future ones.
Many long-term investors therefore use a broad index fund as a core holding. In his 2013 shareholder letter, Warren Buffett wrote that his advice to the trustee of money left for his wife was 90% in a very low-cost S&P 500 index fund and 10% in short-term government bonds; see Warren Buffett’s strategy for how he picks stocks himself.
What are the risks of index funds?
An index fund removes the risk of one company sinking your portfolio, not the risk of the market. When the S&P 500 falls, an S&P 500 fund falls with it. The index lost about 57% from its 2007 peak to its 2009 low, and recovering from a 50% fall takes a 100% gain, as the drawing below shows. Other risks to know:
- Concentration: weighting by market value means a handful of the largest companies can make up a large share of the index.
- One market, one asset type: a US stock index fund is still 100% US stocks. Portfolio diversification covers the other layers.
- Behavior: selling in panic during a bear market locks in the loss the fund was built to ride out.
- Sharia screening: a broad index includes conventional banks and other businesses that Sharia screens exclude; see halal stock investing.
How to start investing in index funds
A simple sequence, whatever amount you start with:
- Decide what the money is for and when you may need it. Money needed within a few years is usually kept out of stocks.
- Open a brokerage account that offers US-listed ETFs; how to buy US stocks walks through the steps.
- Choose the index first, then compare funds on that index by expense ratio, size and trading spread.
- Decide how you will buy: all at once or a fixed amount on a schedule, as in dollar-cost averaging.
- Know what happens to dividends and which taxes apply to you, then write down what you will do in a crash before one comes.