Quick facts about index funds
They pool money from multiple investors to buy the individual stocks, bonds or securities that make up a particular market index
They are a good way to minimize risk because they track a market index, which generally rises in value over time
They're a passive investment with lower fees than mutual funds managed daily by professional brokers — and they often show better returns
Their potential gains and losses are less volatile than those of managed funds that try to beat the market
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
Key things to know about index funds
They're an indirect way to buy the whole market. 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.
By accepting defeat, you actually win. 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 are increasingly popular with investors. According to Morningstar, actively managed mutual funds and exchange-traded funds in the U.S. saw outflows of nearly $514 billion, while passively managed funds saw nearly $1.6 trillion in new money from April 2014 to April 2017. The rise of robo-advisors and passive investing in general have helped fuel interest. See a deeper comparison of index funds and mutual funds here.
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.
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What is an index?
For investors, an index is a measure of the performance of the price of stocks, bonds or other tradable assets in the wider securities 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.
What’s in it for you?
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.
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.
» Examine the cost: Mutual fund return calculator
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.
Some other resources for understanding index funds and their role in your portfolio: