What Are Index Funds?

An index fund is a type of mutual fund or exchange-traded fund that seeks to match the return of a particular index. With regard to investing, an index often tracks the performance of a representative sampling of securities in a market or segment of the market. For example, the well-known Dow Jones Industrial Average (DJIA) measures the return of 30 large U.S. companies that span all business sectors except for transportation and utilities. State Street Global Advisors' SPDR Dow Jones Industrial Average ETF Trust is one index fund that mimics the performance of the DJIA.

Some indexes track the performance of an entire market. For instance, the Dow Jones U.S. Total Stock Market Index represents all stocks listed in the U.S. And the Schwab Total Stock Market Index Fund is a mutual fund that seeks to replicate that index's performance.

Passive Investments

Because the funds' managers aren't actively picking securities to include in their portfolios but are instead buying only those found in the benchmark they're following, index funds are said to be passively managed investments. The main trick for managers is to match the stocks' weightings in the index to their weightings in the fund.

Index Weightings

Many stock indexes—but not the DJIA—are capitalization-weighted, which means those companies whose shares have a higher total value are more strongly represented in the index. The S&P 500 is one such index. It is also float-weighted, which means only the shares available for trading—as opposed to, for example, those held by company executives or a government entity—are considered when calculating market cap.

Index Mutual Funds vs. Index ETFs

Investors are wise to consider both mutual funds and ETFs that track an index. Both index mutual funds and index ETFs often have low expense ratios because they are passively managed.

The essential thing that makes an ETF an ETF—that its shares are traded on an exchange like the stocks of individual companies and so are easily bought and sold whenever you want—provides it an advantage over its mutual fund counterpart. It's easy to get up-to-date prices for index ETFs during the trading day. In contrast, shares of mutual funds are priced once a day, generally after the trading day ends, according to their per-share net asset value (NAV): Their liabilities are subtracted from their total assets, and the result is divided by the number of outstanding shares.

When buying and selling ETFs, you can also use stop and limit orders, which aren't possible with mutual funds.

While both kinds of funds are tax-efficient, ETFs generally offer an even lower tax burden than mutual funds.

One thing to look out for when buying ETFs is the situation in which the market price of a fund's shares is higher than their true value: their NAV. Investors should avoid buying ETF shares when they're trading at a premium to their NAV, but they should take advantage of the market discrepancy when shares are trading at a discount to their NAV.

Advantages of Index Funds

There are four primary reasons why investors buy index funds for their investment portfolio.

  • Index-Matching Performance: Actively managed funds' reason for being is to outperform their benchmark. But year after year, they fail to do so. In 2019, only about 40% of those funds—of all investment strategies—beat the primary benchmark they compare themselves against. For active U.S. stock funds, the performance was even worse, with only 29% outperforming their benchmark, after accounting for fees. Given that track record, matching—rather than trying to surpass—an index's performance seems to be the smarter investment strategy.

One exception to the trend of active fund underperformance in 2019 was the non-U.S. (foreign) stock category: 53% of managers of that kind of fund beat their index.

  • Low Expenses: Because index funds are much more easily managed than their active fund counterparts, their fees are typically lower. And lower fees mean investors get to keep more investable money in their accounts. The annual expense ratio of index funds at some large fund companies is as low as 0.02% or 0.01%. And to entice customers to begin investing with the company, Fidelity Investments offers four index funds that have no management fee at all.

If your index fund has an annual expense ratio of more than 0.10%, you might want to move your money to a similar fund from a different company.

  • Tax-Efficiency: Because they sell holdings less frequently than their actively managed counterparts, index funds generally have lower capital gains distributions. Capital gains occur when investments are sold for more than the price at which they were purchased, and the federal government taxes these gains. The tax rate is higher on holdings held for a year or less, which are considered to be short-term capital gains. Fewer capital gains make for a more tax-efficient investment option.
  • Broad Diversification: An investor can capture the returns of a large segment of the market in one index fund. Index funds often invest in hundreds or even thousands of holdings, offering diversification of risk and reward, whereas actively managed funds typically invest in far fewer. You can gain exposure to many different types of investments by purchasing only a handful of index funds.

Disadvantages of Index Funds

Index funds can never exactly match the performance of their benchmark when they charge fees. However, these funds may also underperform their benchmark for another reason: tracking error. This problem may be caused by not holding the benchmark's constituents according to their weightings in the index.

Another disadvantage of funds that track a capitalization-weighted stock index is that in market downturns, investors are more heavily exposed to the stocks that are most likely to drop the farthest—those that went up the most during the preceding bull market.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Article Sources

  1. S&P Dow Jones Indices. "S&P 500," Download "S&P U.S. Indices Methodology." Accessed May 10, 2020.

  2. Charles Schwab. "ETF vs. Mutual Fund." Accessed May 10, 2020.

  3. Fidelity Investments. "Understanding Premiums and Discounts for ETFs." Accessed May 10, 2020.

  4. Morningstar. "How'd Active Funds Do in 2019? So-So." Accessed May 10, 2020.

  5. Fidelity Investments. "We're Raising the Bar on Value." Accessed May 10, 2020.

  6. SmartAsset. "Understanding Mutual Fund Expense Ratios." Accessed May 10, 2020.

  7. Charles Schwab Investment Management. "Capital Gain Distributions," Page 2. Accessed May 10, 2020.

  8. Envestnet PMC. "A Tracking Error Primer," Page 1. Accessed May 10, 2020.

  9. Larry Light. "Taming the Beast: Wall Street's Imperfect Answers to Making Money," Page 81. Wiley, 2011.