What Are Index Funds, and How Do They Work?

What Are Index Funds?

An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets. 

Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost that an index fund offers.

How an Index Fund Works

“Indexing” is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio whose holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.

There is an index and an index fund for nearly every financial market in existence. In the United States, the most popular index funds track the S&P 500. But several other indexes are widely used as well, including:

• Wilshire 5000 Total Market Index, the largest U.S. equities index
• MSCI EAFE Index, consisting of foreign stocks from Europe, Australasia, and the Far East
• Bloomberg U.S. Aggregate Bond Index, which follows the total bond market
• Nasdaq Composite Index, made up of 3,000 stocks listed on the Nasdaq exchange
• Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies

An index fund tracking the DJIA, for example, would invest in the same 30 large and publicly owned companies that comprise that index.

Portfolios of index funds only change substantially when their benchmark indexes change. If the fund is following a weighted index, its managers may periodically rebalance the percentage of different securities to reflect the weight of their presence in the benchmark. Weighting is a method that balances out the influence of any single holding in an index or a portfolio.

Index Funds vs. Actively Managed Funds

Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio that managers described above.

Lower Costs

One primary advantage that index funds have over their actively managed counterparts is the lower management expense ratio. A fund’s expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.

Because the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others who assist in the stock-selection process. Index fund managers trade holdings less often, incurring fewer transaction fees and commissions. In contrast, actively managed funds have larger staffs and conduct more transactions, driving up the cost of doing business.

The extra costs of fund management are reflected in the fund’s expense ratio and get passed on to investors. As a result, cheap index funds often cost less than 0.65%—0.17% to 0.40% is typical, with some firms offering even lower expense ratios of 0.05% or less—compared to the much higher fees that actively managed funds command, typically 0.77% up to 1.36%.

Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds and struggle to keep up with their benchmarks in terms of overall return.

If you have an online brokerage account, check its mutual fund or ETF screener to see which index funds are available to you.

Better Returns?

Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds. Indeed, a majority of mutual funds fail to beat their benchmark or broad market indexes. For instance, during the five-year period ending Dec. 31, 2022, approximately 87% of large-cap U.S. funds generated a return that was less than that of the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices.

On the other hand, passively managed funds do not attempt to beat the market. Their strategy instead seeks to match the overall risk and return of the market, on the theory that the market always wins.

Passive management leading to positive performance tends to be true over the long term. With shorter time spans, active mutual funds do better. The SPIVA Scorecard indicates that in a span of one year, only about 51% of large-cap mutual funds underperformed the S&P 500. In other words, approximately half of them beat it in the short term. Also, in other categories, actively managed money rules. As an example, more than 35% of midcap mutual funds beat their S&P MidCap 400 Growth Index benchmark in the course of a year.

Example of an Index Fund

Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2021, according to Morningstar Research, investors poured more than $400 billion into index funds across all asset classes. For the same period, actively managed funds experienced $188 billion in outflows.

The one fund that started it all, founded by Vanguard chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. As of Q4 2022, Vanguard’s Admiral Shares (VFIAX) posted an average 10-year cumulative return of 216.49% vs. the S&P 500’s 217.61%, exhibiting a very small tracking error. The expense ratio is 0.04%, and its minimum investment is $3,000.