What Is An Index Fund and How Do They Work?

Index funds have lower costs and less turnover.

Chart of index funds compared to the market.
Index funds offer an easy, efficient way to invest for retirement. Multi-bits/Getty Images

An index fund is a type of mutual fund that offers a low cost, tax-efficient way to invest in a bunch of stock or bonds all at once. You can build an excellent portfolio using only index funds and it will be easy and inexpensive to maintain.

Index funds are categorized as a passive way of investing because the goal of an index fund is not to research companies and pick stocks. The goal of an index fund is to mimic the performance of a chosen index.

For example, an S&P 500 index fund will own the 500 stocks listed by Standard and Poor's as belonging in the S&P 500 index. An index fund won't try to trade in and out of those 500 stocks. It will own all of them.

Owning a stock index fund is a way to invest in capitalism without betting on the success of only a few stocks. If capitalism works, then over time companies will collectively earn profits. Index funds offer a way to participate in this collective success by owning a lot of stocks with the purchase of only one or two funds. I like to use a football analogy when explaining how index funds work. Even if you're not a football fan, I think you'll like the explanation.

Like owning the NFL

Think of it like this; you could bet on who you think will win the Super Bowl this year (and win big, or lose big), but you realize that regardless of who wins, the NFL as a whole will make money as people attend games and buy merchandise.

Unfortunately the NFL is a privately company so you can't buy stock - but if you could it would offer a way to participate in the profits of the game of football in its entirety, rather than betting on only one or two teams.

Although there is not a way to invest in the NFL in its entirety, there is a way to invest in the investment market as a whole; you purchase index mutual funds.

With the right mix of index funds, you can come pretty close to owning all of the stocks that make up the market. Although you won’t know which stocks will do the best from year to year, it won’t matter, as your investments will rise over time as businesses collectively make a profit. As mentioned, this is referred to as a passive investment approach because there is not active trading occurring.

Owning a portfolio of index funds is like owning all the teams in the NFL. There is no need to spend time and money researching each individual team and its players. 

As index funds offer a diversified basket of stocks with a single purchase, it makes them a lower risk way to invest when compared to picking stocks.

Index funds have lower costs

Index funds simply own all the investments that fit a certain criteria. This means they do not need a team of people studying financial statements or talking to upper management about a company's new product line. This means the expense ratio on an index fund is typically much lower than on other types of funds that use an active approach. These lower costs make index funds a great choice. Morningstar's research identifies low fees as one of the best criteria you can use to identify the best performing funds.

Lower turnover means lower taxes

In addition to lower fees, index funds do not trade in and out of investments very frequently. This trading activity is called turnover. Lower turnover usually means less realized capital gains to report each year on your tax return which makes this type of fund very tax efficient. This makes index funds a good choice in taxable accounts (accounts for which you must report interest, dividend and capital gain activity each year).  During times where the market is down you can also exchange one index fund for another to realize a capital loss for tax reasons while maintaining your exposure to the market so you participate in the gains when it goes back up.

Will index funds go down in value?

When the underlying stock or bond market goes down, the corresponding index fund will also go down in value.

If it is a stock fund that is down, stop and ask, do you think companies are forever doomed to keep losing money, and the market will endlessly go down? Or do you think perhaps companies will reorganize, and once again begin making profits? 

It helps to keep in mind that it would be nearly impossible to lose all of your money in an index fund, as that would mean every publicly traded company in that index went out of business at once. If that happens, we all have bigger problems on our hands than our investments.