What is an index fund and how does it work?

Trying to build an investment portfolio on your own can feel overwhelming. One possible way to make it more manageable: investing in index funds. What are index funds? And what are the pros and cons of investing your money in one or more of them?

What is an index fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to mimic the performance of a certain index. (Psst ... an index is a group of different investments, often bundled together because they have something in common.) You can’t invest directly in an index, but you can invest in an index fund, which aims to track the performance of that index. A professional manager pools the money from many investors to invest in the securities that make up the index that the fund is trying to track the performance of.

Take the S&P 500, for example. The S&P 500Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. Put simply, it’s an index that tracks the combined average performance of stock from 500 of the largest US company. If the S&P 500index increases in value, it doesn’t mean that all 500 companies showed gains—but enough did that it brought up the total average value. An S&P 500index fund’s value is based on the performance of the S&P 500^® index. So a share in that index fund would also generally increase in value as the total S&P 500index does.

In other words, buying an index fund could yield a similar result to buying all those individual stocks on your own—but with a lot less legwork and for a lot less money. Investing in an index fund tends to be a more accessible way to invest because a single share of an index fund generally does not cost as much as buying one full share of every stock or bond in a particular index.

Common types of index funds

Index funds can have different themes. Some of the most common include the following.

Broad market: These index funds include investments across companies of all sizes and industries, but they’re generally meant to represent the stock market as a whole.

Sector: As the name implies, these index funds track the performance of a specific sector, such as health care, technology, or consumer goods.

Domestic: These funds track the performance of groups of investments within the US.

Indexes frequently tracked by index funds

In addition to the S&P 500 here are several examples of large indexes tracked by index funds:

Nasdaq Composite Index^®: The Nasdaq is another popular index made up of more than 2,500 stocks. It’s heavy with technology companies over other sectors.

Russell 2000: This broad market index covers more than 2,000 “small cap” stocks, or companies with smaller market capitalization, or valuation. It aims to represent the performance of smaller US companies.

Bloomberg US Aggregate Bond Index: This index looks to track the performance of all types of bonds in the US, including corporate and government bonds.

Advantages of index funds

Reduced risk through diversification

Diversification is an investment strategy designed to help reduce your risk of losing money (though no strategy can eliminate this risk entirely). The idea is not to put all your eggs in one basket. In other words, your portfolio could be less likely to face large losses if you invest in a variety of different stocks spread across different industries vs. only investing in 1 or 2 companies. With index funds, you can immediately invest in a portfolio of hundreds, even thousands, of stocks with a single purchase.

Reduced costs

Even though a professional manager oversees an index fund, they usually charge the investor a lower fee because their work is simple: replicate an existing index vs. build a basket of stocks from scratch and routinely change the fund’s composition. Just how much lower could these fees be? For example, the Fidelity® 500 Index Fund has a gross expense ratio—the percentage of your overall investment that goes to the fund manager—of 0.015% as of March 1, 2024. Remember the expense ratio is the total annual fund operating expense ratio from the fund's most recent prospectus.

In comparison, an actively managed mutual fund where the manager tries to pick the best stocks for potentially higher returns might have an expense ratio of 1% or more, nearly 70 times as much. There are even index funds with 0% net and gross expense ratios, such as the Fidelity® ZERO Total Market Index Fund as of December 30th, 2023.

Reduced human bias and error

Even professional investment managers can have biases and make mistakes during stressful market conditions. Index funds, however, don’t require the manager to make decisions beyond tracking the index.

Reduced investment taxes

When a fund manager sells shares for a gain and passes that profit along to you as a distribution, you and the other investors could owe taxes—even if the gains get reinvested instead of paid out in cash. Investors in actively managed funds that sell frequently owe more taxes than investors in funds that sell less often. Index funds tend not to sell often because they’re simply tracking an index. As a result, investing in index funds—especially index fund ETFs—over funds that sell stocks more often could help keep your tax bill from climbing.

Disadvantages of index funds

While index funds do have benefits, they also have drawbacks to understand before investing.

Average market returns

An index fund tends to include both high- and low-performing stocks and bonds in the index it’s tracking. Any returns you earn would be an average of them all. Still, the historical average return of the general stock market has been quite high. For example, the S&P 500^® has an average return over 10% per year since the 500-company index was introduced in 1957. However, you or a professional investor might be able to earn a higher return if you managed to pick only the best-performing stocks. Just remember: Past performance does not guarantee future results.

Costs to manage the index fund

Yes, index funds tend to be low-cost, but they aren’t always no-cost. Look out for a fund’s expense ratio, aka the operating fees to pay the fund manager. The higher the expense ratio, the bigger cut of your returns go to the fund manager. For some investors, the costs might be worth it because they save you the time, effort, and knowledge required to make all those same investments.

Investment minimums

While some funds don’t put a lower limit on how much you have to invest, others do. That’s called an investment minimum. It’s the smallest amount of money needed to buy into a particular fund. You can use a tool called a fund screener to filter out funds that have investment minimums above what you can afford or want to invest. What’s more, ETF index funds (and even some mutual fund index funds) allow you to purchase fractional shares, meaning you may be able to get started with as little as $1 or $5.

Possible tracking errors

Fund managers are ultimately aiming to track how well a certain index is performing, but sometimes the fund isn’t in lockstep with its target index. This misalignment is called a tracking error. If the tracking error is low, the returns of the fund and the returns of the index being followed (the benchmark) would be the same (or very close to it). If the tracking error is high, the difference in returns between the two would be more noticeable. Look for relatively stable and low—or even positive in the fund performance’s favor—tracking differences over time.

No downside protection

Index funds hold onto the underlying investments in good times and bad, as long as the index being tracked doesn’t change. During a market downturn, an index fund could be likely to lose money. On the other hand, an active investment manager not tracking an index might try to sell before a possible downturn to help minimize losses for investors.

No control over investment holdings

You don’t have any control over the investments in an index fund. Some investors might find it frustrating not being able to remove investments from the fund that they don’t like.

How to invest in an index fund

If you’d like to invest in index funds, the first step is opening an investment account. It could be a retirement account, such as an Individual Retirement Account (IRA) or a nonretirement account, such as a regular brokerage account. If you're starting from scratch, research which broker you’d like to use. Consider the number of index funds they have available, their overall fees, and how user-friendly their investment platform is.

Once your account is open, transfer in some cash to invest. Then check out the available index funds, including what they track, any objectives (like a focus on a specific sector), the performance of the index fund over time, and of course, expense ratios. (Here’s how to tell which index funds best match your investment goals.) After you’ve decided which index funds you’d like to invest in, use the money you’ve transferred into your investment account to buy shares in those index funds.

If you like the idea of investing in index funds, but don’t want the hassle of managing a portfolio on your own, consider a robo advisor—an affordable digital financial service that uses technology to help automate investing. (Psst … Fidelity offers Fidelity Go®, a hybrid service that combines a robo advisor with live, financial coaching.)

FAQs

What is an index fund and how does it work? | Fidelity? ›

Key takeaways. An index fund is a type of mutual fund or exchange-traded fund that aims to mimic the performance of an index, such as the S&P 500^®. Index funds tend to offer investors lower costs and taxes than some other types of funds. They're also relatively lower maintenance.