What Is an Index Fund? An Easy Way to Invest
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Index funds mirror the performance of an existing collection of stocks, such as the S&P 500 index.
Index funds are a passive investment, meaning they aren't managed by a professional.
Index funds often perform better than active funds over the long-term, and they're cheaper.
Index funds can help minimize risk.
What is an index fund?
An index fund is a type of mutual fund whose holdings match or track a particular market index. It's hands-off, and you could build a diversified portfolio earning solid returns using mostly this type of investment.
That's because index funds don’t try to beat the market, or earn higher returns compared with market averages. Instead, these funds try to be the market — buying stocks of every firm listed on an index to mirror the performance of the index as a whole.
Index funds can help balance the risk in an investor's portfolio, as market swings tend to be less volatile across an index compared with individual stocks.
» Ready to get started? Here's how to invest in index funds
What is an index?
For investors, an index is a collection of a group of securities, such as stocks, that are used to measure the health of the broader market. When you hear newscasters talk about the ups and downs of "the Dow," they are talking about how well a specific index — the Dow Jones Industrial Average — performed that day.
As the name suggests, an index fund tracks a particular benchmark index. Some common benchmarks for index funds include:
The S&P 500: As noted above, Standard & Poor's 500 is an index of performance of the 500 largest U.S. public companies.
The Dow Jones Industrial Average: This well-known index (also known as the DJIA) tracks the 30 largest U.S. firms.
Nasdaq: The Nasdaq Composite tracks more than 3,000 technology-related companies.
Russell 2000 Index: Tracks 2000 smaller companies (also known as "small cap," referring to companies with market capitalization of less than $2 billion).
The Wilshire 5000 Total Market Index: The Wilshire 5000 tracks the nearly 7,000 publicly traded U.S. companies, weighted by capitalization or market size.
The MSCI EAFE Index: Tracks performance of large- and mid-cap stocks of firm based in 21 developed nations outside the U.S. and Canada, including nations in Europe, Australasia and the Far East.
How index funds work
Index funds work by investing with a passive management strategy rather than an active management strategy. Active management is when an investment manager actively chooses when to buy or sell specific investments. An index fund buys the securities that make up an entire index. For example, if the index tracks the Standard & Poor's 500 — an index of 500 of the largest companies in the United States — the fund buys shares from every company listed on the index (or a representative sample of stocks). An investor, in turn, buys shares from the fund, whose value will mirror the gains and losses of the index being tracked.
If you're picking individual stocks you're probably not going to outperform the market. Not even the pros do: Research shows that from 2001 to 2016, more than 90% of active fund managers underperformed their benchmark index. So, meeting market gains is a surer bet than beating the market, and that's just what index funds are designed to do.
Index funds and costs
Index funds have fewer fees that erode your returns. The cost of commissions and management of the account, known as expense ratios, are lower for index funds, since they require less work than managed accounts. You're not paying for someone to study financial statements and make calls on what to buy.
Are index funds popular?
Since the first index fund was introduced in 1976 index funds have become incredibly popular. Currently, investors are pulling their money out of actively managed funds and investing more heavily in U.S. stock index funds. According to Morningstar, actively managed funds lost $926 billion in 2022 while passive funds gained $556 billion.
Diversifying with index funds
Index funds are available across a variety of asset classes. Investors can buy funds that focus on companies with small, medium or large capital values, or focus on a sector like technology or energy. These indexes are perhaps less diversified than the broadest market index, but still more so than if you were to buy stock in a handful of companies within a sector.
Individual stocks may rise and fall, but indexes tend to rise over time. With index funds, you won’t get bull returns during a bear market. But you won’t lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.
» DIVE DEEPER: Learn how to invest with Vanguard index funds.
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Why invest with index funds
Index funds help diversify your portfolio. Like all mutual funds, index funds spread risk around and give investors greater choice among conservative and riskier investments, as well as a broader mix of industries and asset classes.
Index funds are simple to understand. Investing strategies can be deeply complex, but index funds have a “what you see is what you get” quality. They promise only to track the financial progress of the index to which they are tethered.
» Check out our top picks for best brokers for mutual funds.