What Is an Index Fund and How Does It Work?
Index funds are designed to track certain financial indexes, such as the total US stock market or the S&P 500. Here’s what you need to know about index funds.
March 1, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
For newcomers to the world of investing, expert advice often tells you to “invest in index funds” instead of picking stocks. But what does this really mean? What is an index fund, and how does it work?
This article will break down everything that you need to know about index funds, from the basic definition to how you can actually invest in these funds.
What is an index fund?
What is an index fund, and how does it work?
An index fund is a financial product that aims to track the price of a certain financial index.
Financial indexes like the Standard and Poor's 500 (S&P 500) or the Dow Jones Industrial Average (DJIA) are set up to track the stock prices of a basket of companies from within that index. For instance, the S&P 500 tracks the prices of 500 of the largest publicly traded companies in America.
An index fund is a financial product that tracks the underlying index. An S&P 500 index fund, such as SPY, tracks the actual S&P 500 index.
The end result is an index fund that can be invested in by anyone, and that tracks the actual performance of the underlying index.
When you buy an index fund, you are essentially buying very small pieces of each company included in that index. Buying an S&P 500 index fund — like FXAIX or SPY — can be done through any investment account, and is much easier than actually buying each underlying stock.
How index funds work
To track the underlying index, fund managers buy stocks in each company that is included in the index — in the amount proportional to that company’s share of the index. They use a strategy known as “market cap weighting.” This means that the more valuable a company, the more weight it is given in the index.
For instance, the “Big Five” tech stocks (Apple, Amazon, Microsoft, Alphabet and Meta) now make up around 20% of the S&P 500 index. So even though there are 500+ firms in the S&P 500, the top handful of companies make up a large percentage of the overall index.
For example, a fund tracking the S&P 500 would purchase shares in all 500+ of the companies included in the index. But the fund would buy many more shares of companies like Apple, Microsoft and Walmart than they would of smaller firms like AutoZone or Chipotle.
Index funds are passively managed, which means that the management companies that offer them do not try to time the market or employ advanced strategies. They will buy and sell holdings occasionally, but only to keep the fund aligned with the underlying index.
Different types of index funds
There are different styles of index funds that can be invested in.
Index funds can be one of two different structures:
Exchange traded funds (ETFs)
The main difference between mutual funds and ETFs is that ETFs trade like stocks, and can be bought and sold at any time during trading hours. Mutual funds, on the other hand, can only be purchased once at the end of each trading day.
Beyond the mutual fund vs. ETF distinction, index funds can also track all sorts of different underlying indexes and types of stocks. Because of this, you can invest in index funds that track things like:
The US large cap index (the largest companies in America)
The US small cap index (smaller publicly traded companies in America)
International indexes (the total stock market outside of America)
Specific-country indexes, such as the Japanese stock market or the German small-cap stock market
Index funds can be set up to track any underlying index, and there are hundreds of different indexes.
The most popular, however, are large-cap stock market indexes such as the S&P 500. In fact, 9 out of 10 of the top index funds by size are either large-cap stock indexes or total market indexes.
How to invest in index funds
You can invest in index funds in most investment accounts, including a 401(k), Roth IRA or a standard taxable brokerage account.
Most index funds are structured as ETFs, which means that you can buy them just like you would a normal stock. Simply type in the fund’s ticker symbol (SPY or FXAIX, for example), and purchase shares in the ETF.
As for which index funds to buy, it’s best to talk to a qualified investment advisor to structure an investment plan that works for you. You can also look online for some of the best index funds.
When investing in an index fund, be sure to pay attention to any investment fees that may be involved. This includes any upfront fees, as well as ongoing management fees (known as the expense ratio).
Upfront fees, such as trading commissions, are charged by the broker. The fees you pay will depend on where you hold your investments. Fortunately, many brokers now offer commission-free trading.
Ongoing investment management fees are automatically subtracted from the performance of the fund, and are charged by the company that actually manages the index fund. Most broad index funds have very low fees — FXAIX charges just 0.015% per year, while SPY charges 0.09% per year.
This means that on a $10,000 investment, FXAIX would cost you $1.50 per year, while SPY would cost $9 per year.
Index funds typically have much lower fees than mutual funds and other actively managed investment funds. As long as you choose broad index funds with relatively low fees, the fees you pay shouldn’t significantly affect the performance of your investments.
Learn more about the basics of investing in our Investing 101 guide.
Index funds for passive investing
Index funds are a great, low-cost way to implement passive investment strategies in your portfolio.
You may have read about “passive investing” strategies before. Essentially, this concept states that investors should buy index funds and utilize a “set it and forget it” approach to investing.
Passive is the opposite of active. In active investing, individuals may buy specific stocks or assets, sell others, and attempt to time short-term swings in the market.
Passive investing is a simpler approach. You simply buy index funds and keep buying index funds until you’re ready to retire. You don’t attempt to time the market, pick winning stocks or utilize any advanced strategies. You simply buy into broad index funds, then wait.
While this approach may sound boring, it’s quite effective. It’s exceptionally difficult to consistently pick individual investments that beat the market — so the best strategy for most people is to simply buy into the stock market using index funds.
In fact, most professional investors and hedge funds actually underperform the stock market. This means that the majority of professional investors would be better off simply buying index funds.
Mastering your finances
Now that you’re armed with knowledge surrounding the question of “what is an index fund,” why not learn more about personal finance? Check out the Tally blog.
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