What is an Index Fund? Definition and How They Work

Written by Kim PinnelliUpdated: 1st Jan 2021
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If investing with low expenses, broad diversification, and little work on your part sounds like the perfect way to invest, it’s time to learn about index funds.

This passive form of investing enables just about anyone to jump into the market with little knowledge and earn average returns.

If you aren’t sure if an index fund is right for you, check out this guide to learn more!

What is an Index Fund? Definition

An index fund is a fund that tracks a market index. It’s a hands-off investment that diversifies your investments and typically provides decent returns.

Index funds don’t promise to beat the market or provide higher than average returns. They work to mimic the market while reducing your risk. It’s the perfect way to diversify your investments with little work on your part.

Index Fund Examples:

Index funds track a particular index, such as:

  • S&P 500– A fund that tracks the S&P 500 invests in the top 500 companies in the United States. All S&P 500 index funds own shares of every company in the index. This diversifies your investment across the board.
  • Nasdaq – Nasdaq funds track technological, financial, biotech, and internet-related companies. Approximately 3,000 companies make up this index.
  • Dow Jones – This index comprises 30 of the ‘top blue-chip companies’ in the United States. Despite its full name, ‘The Dow Jones Industrial’ it doesn’t track industrial companies, but the top-rated companies in the US.
  • Russell 2000 Index – The Russell 2000 index follows 2,000 small-cap stocks.
  • Wilshire 5000 Total Market Index – The Wilshire Index comprises 3,400 companies. It is an average of the overall performance of the stock market in the United States. It’s made up of both small and large-cap stocks.

How Do Index Funds Work?

Index funds are passively managed, unlike mutual funds which are actively managed. In other words, mutual funds try to beat the market by constantly buying and selling investments.

Exchange-Traded Funds or index funds don’t have a human manager buying and selling funds. Instead, a computer puts the fund together, rebalancing it as necessary to mimic an index, not beat it.

Each index fund comprises a certain number of stocks and bonds based on the index it’s trying to mimic. It’s well-diversified which means even when one stock or bond does poorly, another asset will offset it, so you don’t have major gains or losses, but rather meet the market’s return.

Benefits of Index Funds:

  • Low Fees: Because ETFs aren’t actively managed, the fees are much lower. You aren’t paying a human advisor to actively buy and sell investments. Instead, you invest in the fund, and it remains as is except for the necessary rebalancing. Because of the lack of ‘management’, the fees are much lower. On average, ETFs have a 0.4% expense ratio, which means you pay $4.00 for every $1,000 invested.
  • Immediate Diversification: ETFs make diversification easy (and automatic). You don’t have to determine which stocks and bonds offset one another. The index does it for you as you invest in hundreds or even thousands of investments in one index fund.
  • Rewards Long-Term Investors: If you invest for the long-term (at least 10 years), you should see an average 10 percent return. This is much better than investing individually in most stocks and bonds which are unpredictable and often cause investors to bail early. With a diversified fund, you offset the ups and downs, realizing an average return over the course of 10 years of 10 percent (on average).
  • Easy-to-Understand: You don’t have to research individual stocks or know how to buy and sell stocks or options. You invest in an index you think is right for you (S&P 500 is great) and sit back and watch your investments grow. You don’t have to make individual investments or make hard decisions when the market tanks or does well. Anyone can invest in ETFs, and they are especially great for beginners.
  • Not as volatile: You won’t see your investment tank if one company does poorly like you would with individual stocks. You offset the risk by diversifying your investments. You’ll see fluctuations, but they won’t be as drastic as they would with individual funds.

What to Look Out For:

  • Fees Are Applied: All investments have fees, but it’s worth noting that ETFs have expense ratios you must figure into your assets. The fees are lower than most other investments but shouldn’t be ignored.
  • Not Flexible: Once you invest in an ETF, that’s it. You can’t buy and sell individual investments in the index. If you’re looking for something flexible, it’s not an index fund.
  • Return on Investment (ROI) Not as Strong: ETFs mimic market returns – they don’t try to beat it. You’ll see average returns, but nothing spectacular should the market do really well.

What is an Index?

An index is a composite of hundreds or thousands of stocks or bonds. It tracks the overall performance of all companies in the index rather than individual investments. The S&P 500 is the most common example of an index, as is the Dow Jones Industrial Average and Nasdaq.

Learn More: Index Funds vs Mutual Funds

Do Index Funds Have Fees?

All index funds have fees. Read the fine print to know the full fees of a particular index. Most have what they call an expense ratio which incorporates all fees for the investment. The fees are often much lower than mutual funds since they are passively managed.

Related: Motley Fool Review

Are Index Funds Safe?

While no investment is 100% safe, index funds have diversification on their side. When you diversify your investments, you offset the negative with positive effects from another investment. If you stick with the fund long-term, you may see an average 10 percent return.

Index funds are popular for a variety of reasons. First, many investors today want passive investments. They don’t want to worry about actively managing and tracking the performance. Index funds also have low expenses and promise immediate diversification, making it easy to invest in various funds with one investment.

Related: How to Invest $1,000

Who Are Index Funds Best For?

  • Passive Investors
  • Retirement Investors
  • Beginners
  • Young Adults
  • College Students
  • High School Students

Should You Invest in an Index Fund?

If you want to diversify and enjoy low fees, then yes invest in an index fund. If you don’t mind a passive (hands-off) investment that requires little from you except for your monetary contributions, you’ll enjoy the returns and benefits of an index fund. More importantly, you will not feel the stress that is involved with active investing.

Bottom Line: What is an Index Fund?

Any investor can benefit from an index fund, whether you normally actively invest or you’re just starting your investment journey. It’s a great way to keep your portfolio diversified and keep more of your money in your pocket rather than lining the pockets of fund managers.

Places to Buy Index Funds:

Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.