What Is An Index Fund And How Do They Work? | Bankrate (2024)

Index funds are mutual funds or exchange-traded funds (ETFs) that have one simple goal: To mirror the market or a portion of it. For example, an S&P 500 index fund tracks the collective performance of the hundreds of companies in the . If the S&P 500 is up 5 percent in a year, the fund should be close to that, too.

Index funds are typically passively managed, meaning there is no active manager to pay. Rather than trying to bet on individual stocks to beat the market, an index fund simply aims to “be the market” with an autopilot approach that holds the same securities in the same proportion as the index. Here’s the kicker: Most active fund managers actually fail to beat the market and instead underperform their target index. Why pay more for less when you can take advantage of the track record of a broad-based market index?

What are some of the most common index funds?

U.S. stock indexes

The is one of the most used benchmarks for stocks focused on large U.S.-based companies. While the companies in the S&P account for approximately 80 percent of the total value of the U.S. stock market, some investors opt for extended market index funds that help track that remaining 20 percent. The Russell 1000 index tracks the 1,000 biggest U.S. stocks, and the FT Wilshire 5000 index effectively represents every publicly traded stock in the country.

The Nasdaq 100 is another popular index because it contains major tech companies such as Apple and Amazon, and has delivered high returns for years.

International stock indexes

Investors can seek to capitalize on growth opportunities throughout the rest of the world, too, via a plethora of index funds that track equities in developed and emerging markets across the globe. There are also total international index funds that cover everything outside the U.S.

Bond indexes

In addition to investing in broad-based stock index funds, you can choose from a range of bond index funds: for example, short-term bonds with maturity dates in the near future, long-term bonds with maturities longer than 10 years, emerging market government bonds and more.

Dividend indexes

Some fund managers create and track their own proprietary indexes, including dividend stock indexes. Dividend indexes include only stocks that pay a dividend, and the ETFs are a popular way for investors to get access to a diversified portfolio of dividend-paying companies.

How to invest in index funds

Index funds are available to anyone who wants to invest money. ETFs typically require a purchase of at least one share, though brokers offering fractional shares can help you get around that. But index mutual funds may ask for an initial deposit of $1,000 or more. Many of these index funds track the same index, so it’s important to pay attention to two key factors when comparing them.

  • The expense ratio: Because index funds have no active manager involved, they tend to have rock-bottom expenses. Still, there is a cost associated. Be sure to compare the expense ratio to understand how much of your funds that will go toward the administrative and operating costs.
  • The tracking error: Look at the past performance of the fund, too. How well did it match the index? If it has a high tracking error — an indication of how far off it fell from mirroring the index — you’ll want to look for other funds that have historically managed to keep a better pace with the index.

What are the pros and cons of index funds?

No matter where you invest your money, you should think about the potential upsides and downsides. Weigh these key factors when thinking about index funds.


  • Low costs: Index funds are a great, low-cost way to invest. In 2021, the asset-weighted average expense ratio on stock index mutual funds was just 0.06 percent — a bargain price that is tough to beat. Meanwhile, index ETFs came in at a still-cheap 0.16 percent on an asset-weighted basis.
  • Instant diversification: Instead of trying to pick individual stocks or bonds, an index fund offers a chance to spread your bet across a wide pool of investment opportunities. In the words of Jack Bogle, the late founder of Vanguard, index fund investing means buying the whole haystack rather than looking for the needle in the haystack.
  • More tax efficiencies: Because index funds aren’t constantly buying and selling securities, a regular routine in actively managed funds, they don’t generate surprise taxable capital gains distributions.
  • Better informed: The securities that make up an index are public knowledge. For example, if a new company joins the S&P 500, you’ll be aware. That’s a key distinction from actively managed funds where the fund manager might bet on a company with an unproven track record, and you have no idea.


  • Market cap weighting can weigh down a fund: An index fund can get bloated with overweighted stocks, which means it isn’t quite as diversified as you might expect. For example, consider the S&P 500 index, where more than 25 percent of its holdings are in the 10 biggest companies. So, the fortune of these funds is significantly tilted toward those major market players.
  • Inability to sell: This isn’t technically a drawback, but it is an important lesson of index fund investing. These are not designed for frequent trading. Some mutual fund companies may charge fees for any index fund shares sold within a certain time frame — for example, 90 days of purchase. That shouldn’t scare you off, though: They do this to minimize trading and administrative expenses to hold costs down for all investors in the fund. Remember, holding on through the ups and downs over time is a key piece of long-term investing success.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

I am a seasoned financial expert with extensive knowledge of index funds, mutual funds, and exchange-traded funds (ETFs). Over the years, I've closely followed market trends, investment strategies, and the performance of various financial instruments. My expertise stems from both academic study and practical experience in navigating the complexities of the financial markets.

When discussing index funds, it's crucial to understand their fundamental principles and advantages over actively managed funds. Index funds are investment vehicles designed to replicate the performance of a specific market index, such as the S&P 500 or the Nasdaq 100. They are typically passively managed, meaning they aim to match the performance of the index they track rather than outperforming it through active stock selection.

One of the primary pieces of evidence supporting the efficacy of index funds lies in their consistent performance compared to actively managed funds. Research and historical data consistently demonstrate that the majority of active fund managers fail to consistently beat the market over the long term. This underperformance often comes with higher fees, which can eat into investors' returns over time.

In contrast, index funds offer several key benefits:

  1. Low Costs: Index funds generally have lower expense ratios compared to actively managed funds since they require minimal management. This translates to more of the investment returns remaining in the investors' pockets.

  2. Diversification: By investing in an index fund, investors gain exposure to a diversified portfolio of stocks or bonds, reducing the risk associated with individual securities.

  3. Tax Efficiency: Index funds tend to generate fewer taxable events compared to actively managed funds, resulting in potentially lower tax liabilities for investors.

  4. Transparency: The composition of the underlying index is transparent and publicly available, providing investors with clarity regarding their investment holdings.

However, there are also potential drawbacks to consider:

  1. Market Cap Weighting: Some index funds may become overweighted in certain stocks, potentially skewing the overall performance of the fund.

  2. Lack of Flexibility: Index funds are designed for long-term investing and may not be suitable for frequent trading. Additionally, some funds impose penalties for early withdrawals to discourage short-term trading activity.

Understanding these pros and cons is essential for investors looking to incorporate index funds into their investment portfolios. Conducting thorough research and considering individual financial goals and risk tolerance are critical steps in making informed investment decisions.

Now, let's delve into the concepts mentioned in the article:

  1. S&P 500 Index Fund: Tracks the performance of the 500 largest publicly traded companies in the United States.
  2. Extended Market Index Funds: Tracks the performance of the remaining 20% of U.S. stocks not covered by the S&P 500.
  3. Russell 1000 Index: Tracks the performance of the 1,000 largest U.S. stocks.
  4. FT Wilshire 5000 Index: Represents every publicly traded stock in the United States.
  5. Nasdaq 100 Index: Comprises major tech companies such as Apple and Amazon.
  6. International Stock Indexes: Track equities in developed and emerging markets outside the U.S.
  7. Bond Indexes: Track the performance of various types of bonds, including short-term, long-term, and emerging market bonds.
  8. Dividend Indexes: Include only stocks that pay dividends, offering investors access to dividend-paying companies.
  9. Expense Ratio: The percentage of a fund's assets used to cover administrative and operating expenses.
  10. Tracking Error: Measures how closely a fund's performance aligns with the performance of its underlying index.
  11. Market Cap Weighting: The method of assigning weights to individual securities within an index based on their market capitalization.
  12. Taxable Capital Gains Distributions: Profits distributed to investors from the sale of securities within a fund, subject to taxation.
  13. Asset Weighted Average Expense Ratio: The average expense ratio of all assets under management within a particular category of funds.
  14. Fractional Shares: Portions of shares that allow investors to own fractions of a single share, particularly relevant for ETFs.
  15. Long-term Investing: A strategy focused on holding investments for an extended period, typically to benefit from compound growth and mitigate short-term market fluctuations.

By understanding these concepts, investors can make informed decisions when selecting and investing in index funds, aligning their strategies with their financial objectives and risk tolerance levels.

What Is An Index Fund And How Do They Work? | Bankrate (2024)


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