An index fund is a type of mutual fund or exchange-traded fund (ETF) that seeks to track the return of a particular market index. It does so by investing in all or a portion of the securities in that index.
Find out how index funds work and why these passively managed funds are a smart option for low-cost investing.
What Are Index Funds?
An index fund is a mutual fund or ETF that attempts to "track" or achieve the same return as a particular market index. The S&P 500 Composite Stock Price Index, Russell 2000 Index, and Wilshire 5000 Total Market Index are a few major indexes. The fund fulfills its objective to track an index primarily by buying the securities (stocks and bonds, for example) of the companies that make up the index.
As such, index funds provide investors the opportunity to invest indirectly in an entire market without having to invest in the stock of the individual companies that it includes.
How Index Funds Work
A market index measures the performance of a group of securities that represents a certain economic market or sector. But you can't invest directly in a market index. If you want to achieve returns that approximate those of the index, an index fund is a practical option. When you buy shares of an index fund, either through a discount brokerage or an investment firm, you indirectly invest in the securities that they directly invest in.
These funds buy into all or a representative sampling of the companies included in the index to score similar returns. 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 maintains all 30 of those companies in its holdings in order to mimic the performance of the DJIA. In contrast, the Dow Jones U.S. Total Stock Market Index represents all stocks listed in the U.S and maintains and has over 3,700 holdings. The Schwab Total Stock Market Index Fund seeks to replicate that index's performance by maintaining holdings in a representative sample of the companies in the index.
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.
Many stock indexes—but not the DJIA—use market capitalization to weight the securities, which means those companies whose shares have a higher market cap or total value are more strongly represented in the index. The main trick for index fund managers is to match the stocks' weightings in the fund with the weightings in the index.
Pros and Cons of Index Funds
These funds have more advantages than drawbacks:
No exact match of index returns
Market capitalization can cause dramatic downswings
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 lower than 0.05%. And to entice customers to begin investing with the company, Fidelity Investments offers four index funds that have no management fee at all.
- 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. Fewer capital gains make for a more tax-efficient investment option.
The tax rate is higher on holdings held for a year or less, which are considered to be short-term capital gains.
- 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 to balance 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.
There are two main drawbacks to index funds to consider:
- No exact match of index returns: Index funds can never exactly match the performance of their benchmark when they charge fees. Index funds may underperform their benchmark as a result of tracking errors. This problem may be caused by not holding the benchmark's constituents according to their weightings in the index.
- Market capitalization can cause dramatic downswings: Another disadvantage of index 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.
Index Funds vs. Mutual Funds
The term "index fund" isn't interchangeable with "mutual fund." The main reason is that the former term speaks to the objective of the investment, whereas the latter relates to its structure.
An index fund is a fund whose objective is to track a market index. Its structure may be either a mutual fund or an ETF. In contrast, a mutual fund is a company that collects money from multiple investors and uses it to buy stocks, bonds, and other securities to build a portfolio of holdings. Investor shares in the mutual fund represent a portion of those holdings.
Unlike the case with index funds, the investment objective varies by the mutual fund and it's not necessarily to track index returns. With stock funds, for example, the goal is often to achieve above-average returns that potentially exceed those of a market index.
And although an index mutual fund is passively managed, there are also actively managed mutual funds. Such mutual funds are likely to generate higher expenses, taxes, and potentially less diversification than index funds, which are prized for their low expenses and tax efficiency.
|Index fund||Mutual fund|
|Objective is to track the returns of a market index||Objective is fund-dependent and may be to beat the market returns|
|Passively managed||May be actively managed|
|Low-cost and tax-efficient||May be more expensive and less tax-efficient|