What Are Index Funds?

Index Funds Definition and Basics

money_index funds
Learn the definition and basics of index funds. Getty Images

You've heard that investing in index funds can be a smart idea. But what exactly are index funds and why makes them good investments?

In this article, you'll learn the definition of index funds, how index funds work, and the various types of index funds.

Index Fund Definition 

Index funds are mutual funds that are designed to track the returns of a market index. An index is a group of securities that represents a particular segment of the market (stock market, bond market, etc.).

Among the most well-known companies that develop market indexes are Standard & Poors and Dow Jones.

Index funds will hold almost all of the securities in the same proportion as its respective index. Index funds can be structured as a mutual fund, an exchange-traded fund, or a unit investment trust. Several well-known companies that offer index funds are Vanguard, Fidelity and T. Rowe Price.

Index Funds are Passively Managed: What Does This Mean?

Index funds are considered to be passively managed because the portfolio manager of each index fund is replicating the index, rather than trading securities based on his or her view of the potential risk/reward characteristics of various securities. Conversely, an actively-managed fund has a portfolio manager who is buying and selling securities based on an opinion about which securities will accomplish the fund's objectives.

The fact that index funds are passively managed helps keep costs low, which in turn can boost returns in the long run.

The passive nature of index funds also keeps the turnover of the holdings low, which also helps minimize taxes from capital gain distributions that apply to taxable accounts.

Fees of Index Funds

Index funds have expense structures that are similar to other mutual funds. As with other mutual funds, index funds have various share classes depending on the fund company (Class A, B, C, etc.) Generally, the total costs of owning an index fund are less than an actively-managed fund.

However, those total costs depend largely on the fund company offering the funds and the index which the fund tracks. In other words, you can't safely say that all index funds are cheaper than all actively-managed funds.

If you want to invest in diversified U.S. large cap index funds, you might buy the Vanguard 500 Index Fund Investor Shares (VFINX). In doing so, you wouldn't pay an upfront sales charge, and your total ongoing expense ratio is a cheap 0.16%. Don't assume that all index funds are cheap. For example, there are many other index funds that track the S&P 500 Index that have expense ratios as high as 1.50% or more; that's ten times more than the Vanguard 500 Index Fund. After you decide which index you want to buy, be sure to research the costs of the investment options.

Index Funds Come in Different Shapes and Sizes

Indexes come in many varieties. Some indexes may include nearly all of the stocks in the U.S. (such as the Wilshire 5000 Index) or other countries (such as the MSCI Brazil Index). Indexes may also be subsets of other indexes. For example, Standard & Poor's breaks down the S&P 1500 Composite index into a number of different indexes. The S&P 500/Citigroup Value Index includes the stocks with the largest stocks in the S&P 1500 that are considered value stocks.

The S&P SmallCap 600/Citigroup Growth Index includes the smallest stocks in the S&P 1500 that are considered growth stocks.

In recent years, more obscure indexes have been created to allow investors the opportunity to take advantage of markets that are more specialized. Investors who want to invest in commodities, foreign currencies, or socially-responsible companies can now look to index funds.

Updated May 23, 2017, by Kent Thune.