What Is An Index Fund? A Quick Guide On How They Work (2024)

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Even folks new to investing have probably heard someone mention index funds. But what are they and how do they work? This article explores index funds in detail to help you understand how they work, how they compare with other forms of Investing, and whether they should play a role in your investment arsenal.

What Is An Index Fund?

An index fund is an investment vehicle constructed to track a specific, established and documented set of securities, otherwise known as an index. Unlike individual investments that follow a specific security, an index fund follows a diversified portfolio of stocks, bonds and other securities. This does not make them low-risk investments, but it typically is less volatile than an individual stock would be, due to the element of diversification of holdings. Since index funds are passively managed instead of actively managed by a fund manager, they are also a low-cost investment option. It takes less effort and expense for an investment firm to update an established index than to pay someone full time to select stocks.

Key Takeaways

Index funds are a lower-cost investment vehicles that have earned their popularity
They follow a market index instead of individual securities
Exchange Traded Funds (ETFs) have joined mutual funds in the area of index investing
Index funds are not risk-free investments.

How Does An Index Fund Work?

Investing in an index fund is a form of passive investing, as opposed to active investing, such as in a mutual fund where the fund manager actively buys and sells securities to try to obtain the best results for the investors.

There are literally thousands of indexes that track segments of the investment market, but among the most well known are the Dow Jones Industrial Average, the Nasdaq 100 and the S&P 500, all of which track specified areas of the U.S. stock market, each with their own selection methodology. You can’t invest directly in a market index, but there are several funds that track the performance of a market index that you can choose to invest in. The first index funds were mutual funds, but the exchange-traded fund (ETF) industry was in large part based on the idea of taking the index concept and expanding it exponentially, to allow investors to access hundreds or thousands of indexes, and build a portfolio of index funds.

A good example of this would be the Fidelity Total Market Index Fund (FSKAX), which tracks the Dow Jones U.S. Total Stock Market index and owns roughly 4,000 stocks. Like most index funds, the fees of the Fidelity Total Market Index Fund are low, with an ultra low expense ratio of 0.015%

Since index funds track the movement of a market index instead of a handful of stocks, it is more stable and consistent in the long term. The example above has a dividend return of 1.4% and a 10-year average return of 11.1%. For more detailed information about this fund, and others like it, read Best Total Stock Market Index Funds of 2023 and How To Build An Index Fund Portfolio For Income.

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Types Of Index Funds

There was a time, a few decades ago, where the variety of index funds could be listed on a single page. Now, with the growth of the ETF industry to more than $10 trillion dollars and counting, and the index mutual fund business still going strong, the variety and type of index funds requires a database, not a sheet of paper.

All types of funds work off a similar premise: track the index the fund claims to track. But as for the range of choices now available to investors, the list includes broad market stock funds, broad market bond funds, sectors and industries within those markets, thematic tilts on the stock market (i.e. high dividend stocks or low volatility stocks) and many alternative investment index funds. Commodities, currencies and even single stocks are now available in index form, mostly through ETFs.

Do Index Funds Pay Dividends?

The dividend-paying feature of an index fund depends entirely on which target index it mirrors. Not all S&P 500 stocks pay dividends, but the S&P 500 in total does, since there are many stocks that do pay out part of their earnings as dividends each year. So, S&P 500 index funds pay dividends. However, there are some indexes, such as those that target younger growth stocks, where none of the companies in the index pay dividends. In that case, the index fund would not pay out a dividend, since it has no income from the stocks’ dividend payments to pass on to the shareholders of the index fund.

Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually. However, in recent years, in response to investor demand for monthly income, many more ETFs are starting to deliver dividend payments monthly. One feature of some index funds for longer-term investors who do not require dividend payments is that the dividends are automatically reinvested in the fund, so that your compound interest continues to grow over time.

What Fees Do Index Funds Have?

The primary way to understand the fees charged by index funds is to check the fund’s prospectus. The expense ratio includes most but not all the costs that reduce the return of the fund from what it would be without any costs, to what its actual market price is at any point in time. These include compensating management, administrative and legal costs, and marketing costs. With mutual funds, the costs of trading borne by the fund are passed on to investors, but not included in the headline expense ratio. They are disclosed in the fund’s annual and semi-annual report, and in some databases.

ETFs also have expense ratios. However, since they are traded on stock exchanges investors may pay a transaction fee or commission to buy them. Likewise, some mutual fund share types include additional fees to purchase shares, which are either taken out upon purchase or over multiple years.

When it comes to index fund fees, there are many opinions. Generally speaking, the more plain vanilla and accessible an index is, the lower the fees should be to access it. S&P 500 index funds tend to have some of the lowest fees for this reason. However, for more complex indexes, or those more difficult to trade due to the liquidity of the assets traded, expense ratios will typically be higher, perhaps as high as 1% or more. It is truly a get what you pay for situation in terms of complexity for the investor, at least at purchase time.

Index Funds: Benefits & Risks

Many investors choose index funds as their main investment because they consider them a “safe” investment. This is a bit of a misconception as index funds are only as successful or unsuccessful as the index they are tracking.

Benefits

Low fees and costs
Knowing what you own, since holdings are based on the index. Most ETFs update holdings daily, while mutual funds typically do so quarterly.
A diversified portfolio
Simple, hands-off approach to long-term investing.
Better tax efficiency than other forms of investing.

Risks

As with any form of investment there are risks associated with index funds as well.

Inaccurate tracking of the index (investors should check the fund they’re interested in for its tracking record).
Uncertain performance if the market is extreme. When the S&P 500 fell by 33% in only five weeks as it did at the outset of the pandemic in 2020, S&P 500 index funds fell by about that much, too.
Increased governance risk due to the passive nature of index fund investing.

Index Fund Examples

ETFs have been invading the territory once owned by mutual funds. Here are some of the more popular ETFs in different asset classes:

SPDR S&P 500 ETF SPY : Tracks the most popular U.S. stock index
Invesco S&P 500 Equal Weight ETF RSP : Tracks the S&P 500, but weights each stock equally, whereas SPY and most S&P 500-tracking index funds weight the 500 stocks according to the size of the stock.
iShares Core MSCI EAFE ETF IEFA : Tracks the most popular index of non-U.S. stocks, primarily companies from Europe and Asia
Vanguard Total Bond Market ETF BND : Tracks the Bloomberg U.S. Aggregate Bond Index, which is the most popular index representing the U.S. bond market. This ETF holds a diversified mix of government and corporate bonds.

How Do Index Funds Differ From Stocks?

When you invest in individual stocks, you are purchasing a portion of ownership in a specific company. When you invest in an index fund, you are investing in a diverse fund that follows a specific market index. Some investors prefer to purchase specific stocks, so they know that they are investing in specific companies they have researched thoroughly and are confident in the performance of that company. Other investors prefer index funds, so their investment is not reliant on the performance of any one specific company but has the safety net of diversification.

The biggest difference between index funds and individual stocks is risk. An individual company’s performance is more volatile than a diversified index fund. In an index fund investment, if one company does poorly, there is another company doing well to make up the difference and ensure that the investment continues to perform well. When purchasing individual stocks in a specific company, those stocks can have positive returns when the company does well, or negative returns if the company does poorly. And there is always the risk that the company could completely collapse into bankruptcy, obliterating your investment. In an index fund, even if one company in that specific market index collapses, there are other companies in the index to carry your investment forward.

Is An ETF An Index Fund?

Most ETFs in existence today are index funds. But increasingly, active ETFs that are not specifically tied to replicating a particular index are becoming more popular. These “active” ETFs have a manager whose job is to make investment decisions apart from a methodology determined by the rules of an index.

ETFs are typically preferred by an investor who wishes to be more actively involved in their investments, while keeping a diverse portfolio as well as institutional investors who want to take advantage of movements in the market. Index funds are preferred by retail investors who want a passive, long-term strategy to their investment.

Index Funds Vs. Mutual Funds

Mutual Funds are professionally managed funds that can be either passively or actively managed. They pool funds from several investors and when you purchase mutual funds, you are purchasing a portion of the fund, earning proportionate returns. The mutual fund is invested in a variety of stocks, bonds or other securities with the decision making done by the fund manager, removing the stress of cherry-picking individual investments one by one from the investor.

An index fund is a passively managed fund, just like Mutual funds, an index fund is an investment in a variety of stocks, bonds, or other securities. However, there are a few key differences that make Index funds the better choice for long-term investors. Index funds invest in a specific list of investments (such as the S&P 500), aiming to match the returns of the specific market index chosen, over the long-term. This passive strategy is a lower risk than an actively managed Mutual fund, as well as a lower cost.

Mutual Funds invest in a changing list of investments, chosen by the fund manager. Mutual Fund managers aim to outperform the market average of a specific market index, buying and selling, moving the investments, to get the best possible returns for their investors. This can bring better returns, but it also brings slightly higher risk, as well as a higher cost since you are also paying for the fund manager's expertise and involvement in the fund. Mutual funds have an expense ratio built in, and this covers the fees of the Mutual fund, which pays for things like the manager’s salary, bonuses and benefits, the office expenses, and cost of marketing the fund. Besides paying the fees, the fund expense ratio means there is less money in the fund to be earning returns for the investor. For more information on investing in Mutual Funds, this article on building your Mutual fund portfolio, is helpful for the beginning investor.

Are Index Funds Good Long-Term Investments?

With their low-cost diversification and transparency (you can see what you own every day in the case of most ETFs) long-term investors can potentially benefit from an index fund being a core part of an investment strategy. However, investors looking for large short-term gains, it depends entirely on which index funds you choose. Isolated sectors or industries may have quick periods of high returns, though that is less likely for a more broadly diversified index fund. That said, investing tactically across a set of ETFs is something an increasing number of active investors are doing to try to profit from shorter-term market movements. ETFs aid in this approach since they allow instant access to a wide number of stock and bond baskets via the ETF wrapper, traded whenever the stock exchange is open.

Bottom Line

Index funds are less complicated, lower cost Investment vehicles for those wishing to passively invest. Over the past few decades, they have earned their place at the center of many investment plans. Investors need to do their homework and determine how to balance reward and risk potential in a way that is personalized to them.

Index Fund FAQs

What Are Low Cost Index Funds?

A low cost index fund is an index fund where the fees are kept low, as most index funds are, due to being a passive investment vehicle. The fund is set up by the fund manager to follow a specific market index and is altered occasionally when the market index changes (when companies are removed or added to the market index that the fund tracks). This is different from actively managed mutual funds where the fund manager is actively moving investments to try and follow the best returns for the shareholders.

Are Index Funds Good Investments For Beginners?

Yes, index funds are a great option for beginner investors. They are not as complex as investing in individual stocks and don’t require you to have an in-depth understanding of the stock market. In fact, this passive investment strategy is good to have as at least part of your long-term investment portfolio for any investor, regardless of your experience level.

Where Can You Invest In Index Funds?

Index funds can be purchased through most brokerage accounts. Mutual fund trades will be effective at the end of the market day, at that day’s closing price. ETFs trade all day when the market is open, just as stocks do, so the price of your buy or sell trade is determined right when you transact.

What Is An Index Fund? A Quick Guide On How They Work (2024)